, Volume 28, Issue 4, pp 353-391
Date: 31 May 2007

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

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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.

Earlier versions of this paper were presented at the 5th Conference of the Swiss Society for Financial Market Research (SGF), at the 9th Annual Meeting of the German Finance Association (DGF), at the 2004 Basel Meeting of the European Financial Management Association (EFMA), the 2005 WHU Campus for Finance Conference on Options and Futures, the 12th Global Finance Conference (GFC) in Dublin, the 2005 Annual Meeting of the Northern Finance Association (NFA) in Vancouver and at the 2006 Annual Meeting of the Eastern Finance Association (EFA) in Philadelphia. We especially appreciate the valuable comments of Tim R. Adam, Axel F. A. Adam-Müller, Rakesh Bharati, René Garcia, Amrit Judge, Olaf Korn, Gunter Löffler, Lars Norden, Larry D. Wall, Josef Zechner and two anonymus RQFA referees. Of course, any remaining errors are our own.