Optimal Financial Leverage and the Determinants of Firm's Hedging Policies under Price, Basis and Production Risk

A new theoretical model of hedging is derived. Risk neutrality is assumed. The incentive to hedge is provided by progressive tax rates and bankruptcy laws. Optimal hedge ratios and the relationship with leverage, yield risk, basis risk, and fnancial risk is determined using alternative assumptions. An empirical example is provided to show changes in assumptions affect optimal hedge ratios for a wheat and stocker steer producer. Results show that hedging increases with increasing leverage and and increases at an even higher rate when the probability of bankruptcy is positive. The trade off between the cost and the tax-reducing benefts of hedging affects signifcantly the decision to hedge. The farmer wants to hedge to reduce tax payments, expected bankruptcy losses, interest rates and decrease the probability of bankruptcy. Even when the cost of hedging is a small portion of total cost, farmers may have no incentives to hedge when this cost is higher than the reduction in tax payments and the frm is in good fnancial position (i.e. low leverage ratios). For high levered frms, hedging reduces expected bankruptcy losses, and this effect may be considerably greater than the cost of hedging, making hedging very attractive. It is also shown that as basis risk increases, the optimal decision may well be not hedge at all.