Corporate Hedging and Financial Contracting

Abstract

This paper develops a theory of corporate hedging in a financial contracting framework. In an economy with moral hazard and state uncertainty, the optimal financial contract incorporates both non-monitoring (arm’s length) finance and monitoring (bank) finance, and its payoff is equity-like. When external investors (e.g., the bank) face additional costs of holding equity, hedging mitigates incentive problems related to debt contracts and, thus, lowers the cost of debt and enables the firm to substitute debt for equity in its capital structure. The model generates empirical implications that are consistent with extant empirical evidence. For example, hedging will be more likely to be used with bank finance than with non-monitoring finance; the optimal hedge ratio will be positively related to the level of bank finance; and the optimal hedge ratio should be strictly less than 1.