Reasons Motivating Firms to Hedge: A Review of the Empirical Literature

This paper undertakes a review of the reasons as to why firms hedge. Basically, the empirical literature pertaining to hedging is split into three main parts. The first part of the literature underscores the strong incentives for shareholders to hedge by virtue of three main forces which comprise the convex tax structure, expected financial distress costs along with underinvestments under imperfect capital markets. The second part shows that, the managers of firms are induced to hedge not only under managerial risk aversion motive but also to send strong signals of their skills to the market. Finally, the hedging literature considers the alternative modes of hedging which may be derivative-based or non-derivative-based. The paper also points out the need of being cautious when dealing with the empirical evidences based on hedging since results are not always foolproof for diverse reasons.