HOW FIRMS MANAGE RISK: THE OPTIMAL MIX OF LINEAR AND NON‐LINEAR DERIVATIVES

Abstract

This paper provides guidance on how corporations should choose the optimal mix of “linear” and “non‐linear” derivatives. Linear derivatives are products such as futures, forwards, and swaps, whose payoffs vary in linear fashion with changes in the un‐derlying asset price or reference rate. Non‐linear derivatives are contracts with option‐like payoffs, including caps, floors, and swaptions.A company's optimal hedging position should generally consist of linear contracts because of their effective‐ness in smoothing corporate cash flows. But as the firm's business (quantity) risk increases, its use of linear contracts will decline due to costs associated with overhedging. At the same time, there will be a shift towards the use of non‐linear contracts. The degree of substitution of non‐linear for linear in‐struments will depend on the relation‐ship between the quantities to be hedged and market prices. A negative relationship will tend to exacerbate the substitution effect while a positive re‐lationship will dampen the effect. An empirical examination of corporate derivative holdings provides support for all of the major hypotheses.