Journal of Financial Economics 87 (2008) 706–739
Financial distress and corporate risk management:
Theory and evidence
Ross School of Business, University of Michigan, Ann Arbor, MI 48109, USA
Received 28 February 2006; received in revised form 2 April 2007; accepted 10 April 2007
Available online 14 December 2007
This paper extends the current theoretical models of corporate risk-management in the presence of ﬁnancial distress
costs and tests the model’s predictions using a comprehensive data set. I show that the shareholders optimally engage in ex-
post (i.e., after the debt issuance) risk-management activities even without a pre-commitment to do so. The model predicts
a positive (negative) relation between leverage and hedging for moderately (highly) leveraged ﬁrms. Consistent with the
theory, empirically I ﬁnd a non-monotonic relation between leverage and hedging. Further, the effect of leverage on
hedging is higher for ﬁrms in highly concentrated industries.
r 2008 Elsevier B.V. All rights reserved.
JEL classiﬁcation: G30; G32
Keywords: Hedging; Risk-shifting; Asset substitution; Derivatives
This paper develops and tests a theory of corporate risk management in the presence of ﬁnancial distress
costs. The existing literature shows that hedging can lead to ﬁrm value maximization by limiting deadweight
losses of bankruptcy (see Smith and Stulz, 1985).
These models justify only ex-ante risk-management
ARTICLE IN PRESS
0304-405X/$ - see front matter r 2008 Elsevier B.V. All rights reserved.
This paper is based on a chapter of my Ph.D. dissertation at Cornell University. I would like to especially thank an anonymous referee
for several useful suggestions during the reviewing process. I am grateful to George Allayannis, Warren Bailey, Sugato Bhattacharya,
Sreedhar Bharath, Sudheer Chava, Thomas Chemmanur, Wayne Ferson, Ken French, John Graham, Robert Goldstein, Yaniv Grinstein,
Jerry Haas, Pankaj Jain, Kose John, Haitao Li, Roni Michaely, M.P.Narayanan, Maureen O’Hara, Paolo Pasquariello, Mitch Petersen,
Uday Rajan, William Schwert (the editor), David Weinbaum, Rohan Williamson, and seminar participants at Boston College, Cornell,
Darden, Emory, London Business School, University of Michigan, Notre Dame, University of Rochester, The Lehman Brothers Finance
Fellowship Competition 2003, and the Western Finance Association’s 2005 meetings for valuable comments and suggestions. I am
particularly grateful to Bob Jarrow and Bhaskaran Swaminathan for their advice. All remaining errors are mine.
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Other motivations for corporate hedging include convexity of taxes, managerial risk-aversion (Stulz, 1984; Smith and Stulz, 1985)
underinvestment costs (Froot, Scharfstein, and Stein, 1993), and information asymmetry (DeMarzo and Dufﬁe, 1991, 1995). See also
Breeden and Viswanathan (1996) and Stulz (1996).