How Should Firms Hedge Market Risk?

Bhagwan Chowdhry and Eduardo Schwartz

Critical Finance Review, 2016, vol. 5, issue 2, 399-415

Abstract: 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.

Keywords: Finance (search for similar items in EconPapers)
JEL-codes: G30 (search for similar items in EconPapers)
Date: 2016
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