Who hedges more when leverage is endogenous? A testable theory of corporate risk management under general distributional conditions

Who hedges more when leverage is endogenous? A testable theory of corporate risk management under... This paper develops a theory of a firm’s hedging decision with endogenous leverage. In contrast to previous models in the literature, our framework is based on less restrictive distributional assumptions and allows a closed-form analytical solution to the joint optimization problem. Using anecdotal evidence of greater benefits of risk management for firms selling “credence goods” or products that involve long-term relationships, we prove that those optimally leveraged firms, which face more convex indirect bankruptcy cost functions, will choose higher hedge ratios. Moreover, we suggest a new approach to test this relationship empirically. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Quantitative Finance and Accounting Springer Journals

Who hedges more when leverage is endogenous? A testable theory of corporate risk management under general distributional conditions

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Publisher
Kluwer Academic Publishers-Plenum Publishers
Copyright
Copyright © 2007 by Springer Science+Business Media, LLC
Subject
Finance; Corporate Finance; Accounting/Auditing; Econometrics; Operation Research/Decision Theory
ISSN
0924-865X
eISSN
1573-7179
D.O.I.
10.1007/s11156-007-0017-z
Publisher site
See Article on Publisher Site

Abstract

This paper develops a theory of a firm’s hedging decision with endogenous leverage. In contrast to previous models in the literature, our framework is based on less restrictive distributional assumptions and allows a closed-form analytical solution to the joint optimization problem. Using anecdotal evidence of greater benefits of risk management for firms selling “credence goods” or products that involve long-term relationships, we prove that those optimally leveraged firms, which face more convex indirect bankruptcy cost functions, will choose higher hedge ratios. Moreover, we suggest a new approach to test this relationship empirically.

Journal

Review of Quantitative Finance and AccountingSpringer Journals

Published: May 31, 2007

References

  • A further empirical investigation of the bankruptcy cost question
    Altman, E. I.
  • On the existence of an optimal capital structure: Theory and evidence
    Bradley, M.; Jarrell, G. A.; Kim, E. H.
  • How firms should hedge
    Brown, G. W.; Toft, K. B.
  • Bankruptcy risk and optimal capital structure
    Castanias, R.
  • An analysis of the underreported magnitude of the total indirect costs of financial distress
    Chen, G. M.; Merville, L. J.
  • A note on forward price and forward measure
    Chen, R.; Huang, J.
  • Corporate hedging: The relevance of contract specifications and banking relationships
    Cooper, I. A.; Mello, A. S.
  • Structured debt and corporate risk management
    Culp, C. L.; Furbush, D.; Kavanagh, B. T.
  • Risk management: Coordinating corporate investment and financing policies
    Froot, K. A.; Scharfstein, D. S.; Stein, J. C.
  • Tax incentives to hedge
    Graham, J. R.; Smith, C. W.

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