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3.7 Why Corporations Hedge

Learning Objective

  • Why should corporations hedge? Financial theory tells us that in a perfect world, corporations are risk neutral. Students can learn in this section the reasons why large companies hedge risk, and, in particular, why they buy insurance.

Financial theory tells us that corporations are risk neutral. This is because only the systematic risk matters, while a particular company can diversify the idiosyncratic riskSystematic risk is the risk that everyone has to share, each according to his/her capacity. Idiosyncratic risk, on the other hand, falls only on a small section of the population. While systematic risk cannot be transferred to anyone outside since it encompasses all agents, idiosyncratic risk can be transferred for a price. That is why idiosyncratic risk is called diversifiable, and systematic is not. The economy-wide recession that unfolded in 2008 is a systematic risk in which everyone is affected. away. If we think about a large company held by a large number of small shareholders like us, then we’d prefer that the company not hedge its risks. In fact, if we wanted to hedge those risks we can do it ourselves. We hold a particular company’s shares because we are looking for those particular risks.

Look back at Figure 3.4 "A Utility Function for a Risk-Neutral Individual". Since firms are risk neutral, their value function is the straight line that appears in the figure. Thus corporations will hedge risk only at their AFP, otherwise they will not. But we know that insurance companies cannot really sell policies at AFP, since they also have to cover their costs and profits. Yet we find that corporations still buy these hedging instruments at greater price than AFP. Therefore, to find a rationale for corporations hedging behavior, we have to move beyond the individual level utility functions of risk aversion.

The following are several reasons for companies hedging behavior:

  1. Managers hedge because they are undiversified: Small shareholders like us can diversify our risks, but managers cannot. They invest their income from labor as well as their personal assets in the firm. Therefore, while owners (principals) are diversified, managers (agents) are not. Since managers are risk averse and they control the company directly, they hedge.
  2. Managers want to lower expected bankruptcy costs: If a company goes bankrupt, then bankruptcy supervisors investigate and retain a part of the company’s assets. The wealth gets transferred to third parties and constitutes a loss of assets to the rightful owners. Imagine a fire that destroys the plant. If the company wants to avoid bankruptcy, it might want to rebuild it. If rebuilding is financed through debt financing, the cost of debt is going to be very high because the company may not have any collateral to offer. In this case, having fire insurance can serve as collateral as well as compensate the firm when it suffers a loss due to fire.
  3. Risk bearers may be in a better position to bear the risk: Companies may not be diversified, in terms of either product or geography. They may not have access to broader capital markets because of small size. Companies may transfer risk to better risk bearers that are diversified and have better and broader access to capital markets.
  4. Hedging can increase debt capacity: Financial theory tells us about an optimal capital structureA company’s optimal mix of debt and equity financing. for every company. This means that each company has an optimal mix of debt and equity financing. The amount of debt determines the financial risk to a company. With hedging, the firm can transfer the risk outside the firm. With lower risk, the firm can undertake a greater amount of debt, thus changing the optimal capital structure.
  5. Lowering of tax liability: Since insurance premiums are tax deductible for some corporate insurance policies, companies can lower the expected taxes by purchasing insurance.
  6. Other reasons: We can cite some other reasons why corporations hedge. Regulated companies are found to hedge more than unregulated ones, probably because law limits the level of risk taking. Laws might require companies to purchase some insurance mandatorily. For example, firms might need aircraft liability insurance, third-party coverage for autos, and workers compensation. Firms may also purchase insurance to signal credit worthiness (e.g., construction coverage for commercial builders). Thus, the decision to hedge can reduce certain kinds of information asymmetry problems as well.

We know that corporations hedge their risks, either through insurance or through other financial contracts. Firms can use forwards and futures, other derivatives, and option contracts to hedge their risk. The latter are not pure hedges and firms can use them to take on more risks instead of transferring them outside the firm. Forwards and futures, derivatives, and option contracts present the firm with double-edged swords. Still, because of their complex nature, corporations are in a better position to use it than the individuals who mostly use insurance contracts to transfer their risk.

Key Takeaways

  • The student should be able to able to distinguish between individual demand and corporate demand for risk hedging.
  • The student should be able to understand and express reasons for corporate hedging.

Discussion Questions

  1. Which risks matter for corporations: systematic or idiosyncratic? Why?
  2. Why can’t the rationale of hedging used to explain risk transfer at individual level be applied to companies?
  3. Describe the reasons why companies hedge their risks. Provide examples.
  4. What is an optimal capital structure?