How Firms Should Hedge

Gregory W. Brown · Klaus Bjerre Toft

175 citations0/0 files storedReview of Financial Studies

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Risk Management in Financial Firms Stochastic processes and financial applications Capital Investment and Risk Analysis

Abstract

Substantial academic research explains why firms should hedge, but little work has addressed how firms should hedge. We assume that firms can experience costly states of nature and derive optimal hedging strategies using vanilla derivatives (e.g., forwards and options) and custom “exotic” derivative contracts for a value-maximizing firm facing both hedgable (price) and unhedgable (quantity) risks. Customized exotic derivatives are typically better than vanilla contracts when correlations between prices and quantities are large in magnitude and when quantity risks are substantially greater than price risks. Finally, we discuss how our model may be applied in practice.

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References

1958The Cost of Capital, Corporation Finance and the Theory of Investment 1977Determinants of corporate borrowing 1985The Determinants of Firms' Hedging Policies 1993Risk Management: Coordinating Corporate Investment and Financing Policies 1996Who Manages Risk? An Empirical Examination of Risk Management Practices in the Gold Mining Industry 1993On the Determinants of Corporate Hedging 1996RETHINKING RISK MANAGEMENT 1997Why Firms Use Currency Derivatives

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