Hedging and debt overhang: a conceptual note

Jacques A. Schnabel

Journal of Risk Finance, 2015, vol. 16, issue 2, 164-169

Abstract: Purpose - – This paper aims to examine the nexus between hedging, which reduces the volatility of corporate assets, and the anomaly of debt overhang, whereby corporate management is motivated to reject positive net present value (NPV) projects. The question of whether hedging ameliorates or aggravates debt overhang is addressed. Design/methodology/approach - – The Black–Scholes isomorphism between common shares and call options is exploited to determine the allocation of a project’sNPVbetween debt- and stock-holders. The effect of hedging on thisNPV-partitioning is then gauged to determine the resulting likelihood of debt overhang. Findings - – If the volatility of corporate assets is below a critical maximum, hedging ameliorates debt overhang consistent with extant theoretical research. However, above that critical value of volatility, hedging aggravates debt overhang. Originality/value - – The novel result of this note, namely, hedging may exacerbate debt overhang, is demonstrated both analytically and intuitively. The latter is explained by allusion to a second agency-theoretic conflict between debt- versus stock-holders, namely, risk shifting. The disparate effects of hedging on debt overhang imply a non-monotonic relationship between metrics for these two variables, which is a phenomenon that extant empirical studies have failed to take into account.

Keywords: Hedging; Debt overhang; Non-monotonic relationship; Risk shifting; Underinvestment problem (search for similar items in EconPapers)
Date: 2015
References: Add references at CitEc
Citations:

Downloads: (external link)
https://www.emerald.com/insight/content/doi/10.110 ... d&utm_campaign=repec (text/html)
https://www.emerald.com/insight/content/doi/10.110 ... d&utm_campaign=repec (application/pdf)
Access to full text is restricted to subscribers

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eme:jrfpps:jrf-10-2014-0140

DOI: 10.1108/JRF-10-2014-0140

Access Statistics for this article

Journal of Risk Finance is currently edited by Nawazish Mirza

More articles in Journal of Risk Finance from Emerald Group Publishing Limited
Bibliographic data for series maintained by Emerald Support ().