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How Should Firms Hedge Market Risk?

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  • Chowdhry, Bhagwan
  • Schwartz, Eduardo

Abstract

Consider a firm whose stock returns are affected by market returns and an idiosyncratic market-orthogonal factor. The level of the firm’s cash flows depends on the level of the market and the level of the idiosyncratic factor multiplicatively because of compounding. Although a large hedge against the market index minimizes the variance of cash flows, such a hedge does not minimize the costs of financial distress associated with low cash flow realizations below a debt threshold. A hedge ratio based on asset-rate-of-return regression estimates is then incorrect. This holds even in continuous time and with dynamic hedging policies. Our paper provides a simple heuristic for corporations wishing to hedge out the adverse consequences of market risk.

Suggested Citation

  • Chowdhry, Bhagwan & Schwartz, Eduardo, 2016. "How Should Firms Hedge Market Risk?," Critical Finance Review, now publishers, vol. 5(2), pages 399-415, December.
    • Handle: RePEc:now:jnlcfr:104.00000023
    DOI: 10.1561/104.00000023
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    Keywords

    Finance;

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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