Corporate hedging and the cost of debt

David Christopher Alley

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: This paper develops a set of necessary conditions to justify corporate hedging using a general cash flow model of firm value when the cost of debt is convex in both level of debt and the value of the firm's assets. It is shown that hedging is value-creating under a wider range of conditions than suggested in the existing hedging literature. By hedging, the firm is able to rely less on externally generated funds and, therefore, will invest at a higher level than when using borrowed funds. Furthermore, if external financing is necessary, the firm will be able to borrow at a lower cost per dollar of face value of debt if it hedges its cash flows. Then, a simulation is developed using a Black-Scholes-Merton contingent claim pricing model to show the gains in share value by using a simple static delta hedging strategy.

Date: 2004-01-01
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