Theoretical explanations of corporate hedging

Abstract

This study surveys theoretical models providing alternative rationales for corporate hedging.

Across the revised models, corporate hedging is defined, variously, as any insurance contract, as any activity reducing the correlation of the firm value with some random variable and as holding derivative financial instruments.

Alternative models can be separated into those arguing that reducing risk at the corporate level may be value-enhancing (failure of the Modigliani-Miller theorem) and those arguing that corporate hedging is an outgrowth of shareholder-manager conflicts (failure of the Fisher Separation theorem). Few studies model or simply suggest possible incentives to increase risks through derivatives.

This survey emphasises the relevance of models that do not focus on the firm’s capital structure only, but rather conceive hedging as a tool to coordinate both financial capital and investment. This stream is potentially important to interlink financial and real decisions under uncertainty.

A thorough examination of the contributions within the so called “managerial risk aversion hypothesis”, often interpreted as providing similar predictions, reveals that different, sometimes opposite, predictions can be identified and lead to the conclusion that most of the empirical tests on corporate hedging based on stock options can be considered uninformative on the managerial incentives to hedge.