Hedging Corporate Cash Flow Risk

We consider optimal hedging decisions for a firm whose stock returns are affected by market returns and an idiosyncratic factor that is orthogonal to the market return. We show that the level of firm’s cash flows depend on the level of the market and the level of the idiosyncratic factor multiplicatively because of compounding. Minimizing the variance of the cash flow requires a substantial offsetting position in the market index. However, minimizing the costs of financial distress associated with low cash flow realizations is complex and requires only a modest hedge against the market factor. This insight holds even in continuous time and with dynamic hedging policies. We clarify that using return regressions to measure economic exposure to generate optimal hedging deltas is erroneous and that hedging transaction exposure to idiosyncratic risks such as exchange risks is sensible.