Corporate Hedging: What, Why and How?

This paper explores the rationale for corporate risk management. Following Smith and Stulz (1985) and Mayers and Smith (1987), the assumption is made that firms can contractually commit to bondholders to maintain a particular risk management policy, or asset volatility. With that as a starting point, the essay derives the optimal hedge portfolio, examines this portfolio's robustness to variance-covariance misestimation, and proposes a new motive for corporate risk management; a firm that hedges its risk increases its optimal amount of debt and so realizes more tax benefits from leverage. Using the capital structure model of Leland (1994), three impacts of risk-reduction on shareholder value are measured: the increase in tax benefits, the reduction of bankruptcy costs and the reduction in the potential cost of the underinvestment problem. The essay's motivation is to serve as a guide to chief financial officers regarding the benefits of risk management and the sources of those benefits, so that risk management can be undertaken in a way that enhances shareholder value, rather than for its own sake.