Why Firms Do Not Hedge Market 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 the 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 cash flows requires a substantial offsetting position in the market index. However, minimizing the costs of financial distress associated with low cash flow realizations below a threshold requires only a modest hedge against the market factor when firm debt levels are also moderate. This 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 may be erroneous and we provide a simple rule of thumb for hedging market risk.