Hedging and Liquidity

Abstract

This article develops a model for evaluating alternative hedging strategies for financially constrained firms. A key advantage of the model is the ability to capture the intertemporal effects of hedging on the firm’s financial situation. We characterize the optimal hedge. A wide range of alternative hedging strategies can be specified and the model allows us to determine in each case if the hedging strategy raises or lowers firm value and by how much. We show that hedging firm value, hedging cash flow from operations and hedging sales revenue are not optimal. The article highlights the fact that every hedging strategy comes packaged with a borrowing strategy which requires careful consideration. Futures markets often provide the most liquid and convenient instruments for managing risk. However, because futures contracts are marked to market, it is often impossible to simultaneously hedge cash flows and values. For example, a futures contract that locked in the value of gold that a corporation planned to extract in one year would generate an uncertain cash flow pattern over the year. This article examines how liquidity and cash flow timing problems associated with different hedging strategies can affect a firm’s value. In our model, the objective for hedging is to increase the firm’s financial flexibility. An optimal hedge maximizes the firm’s liquidityslack in the form of excess cash or unused debt capacitywhen liquidity is most valuable. This lowers the danger of costly financial distress, reduces the effective cost of external financial constraints, and makes value maximizing investments affordable. A firm with no financial constraints does not gain from hedging, and the higher the firm’s financial constraints the greater the potential value of hedging. The value of hedging depends critically on the design of the hedging strategy. We show that the optimal hedge minimizes the variability in the marginal value of the firm’s cash balances. Such a hedge efficiently redistributes cash balances across different states and periods, taking cash from those states for which the marginal cost of the financial constraint is low and giving cash to those states for which the marginal