How Should Firms Hedge Market Risk?

Chowdhry, B and Schwartz, E (2016) How Should Firms Hedge Market Risk? Critical Finance Review, 5 (2). pp. 399-415. ISSN 2164-5744

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Consider a firm whose stock returns are affected by market returns and an idiosyncratic market-orthogonal factor. The level of the firm’s cash flows depends on the level of the market and the level of the idiosyncratic factor multiplicatively because of compounding. Although a large hedge against the market index minimizes the variance of cash flows, such a hedge does not minimize the costs of financial distress associated with low cash flow realizations below a debt threshold. A hedge ratio based on asset-rate-of-return regression estimates is then incorrect. This holds even in continuous time and with dynamic hedging policies. Our paper provides a simple heuristic for corporations wishing to hedge out the adverse consequences of market risk.

Item Type: Article
Additional Information: The research article was published by the author with the affiliation of UCLA Anderson School
Subjects: Finance
Date Deposited: 03 Aug 2023 21:31
Last Modified: 03 Aug 2023 21:31

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