The minimum variance hedge and the bankruptcy risk of the firm

Abstract

In this paper, we analyze the influence of hedging with forward contracts on the firm's probability of bankruptcy (POB). The minimization of this probability can serve as a substitute for the maximization of shareholders' wealth. It is shown that the popular minimum variance hedge is generally neither necessary nor sufficient for the minimization of the firm's POB. Moreover, our model suggests a correction of the widespread view that a reduction in the variance of the future value of the firm is inevitably accompanied by a reduction in its default risk. We derive an analytical solution for the variance-minimizing hedge ratio of a firm exposed to both input and output price uncertainty that takes into account the issue of correlation. Based on this solution, we provide a graphical analysis to prove our claim that there is a fundamental difference between hedging policies focused on bankruptcy risk and those following conventional wisdom even if positive correlation constitutes a ''natural'' hedge. D

What do we really know about corporate hedging? A meta-analytical study

“…This increases the risk of bankruptcy and the firm might encounter direct and indirect costs of financial distress (Jensen and Meckling 1976). Since corporate hedging lowers cash flow volatility and therefore also the default probability, it reduces expected costs of financial distress and adds value to the firm (Brown and Toft 2002;Hahnenstein and Röder 2003;Smith and Stulz 1985;Stulz 1996). Thus, we receive the following hypothesis H2, which we test by dividend yield, interest coverage ratio, leverage ratio, liquidity, profitability, firm size, and tangible assets as proxy variables: H2: Firms use corporate hedging as an instrument to reduce the risk of bankruptcy and financial distress costs.…”

Business decision-making of power generators in competitive electricity market

“…Therefore, we chose them as the hedging instruments in this work. We will also provide the formulas of classical minimum variance hedging [43] , [44] , [45] , [46] and hedging efficiency, such that power generators can calculate for their own specific situations.…”

Corporate hedging under a resource rent tax regime

“…Nevertheless, the result on the minimum variance hedge differs slightly from Brown and Toft's equation (14) in that the contribution margin ( P -c) affects the minimum variance hedge ratio. Clearly, variance minimization is neither a necessary nor a sufficient strategy for value maximization (a related result is derived by Hahnenstein and Röder (2003)). Note that these results hold for arbitrarily small c 2 and a positive c 1 ; any hedge ratio is optimal (not only the minimum variance solution) for c 2 = 0, including the no-hedge solution a* = 0.…”