Critical Finance Review > Vol 5 > Issue 2

How Should Firms Hedge Market Risk?

Bhagwan Chowdhry, University of California, Los Angeles, Anderson School of Management, USA, bhagwan@anderson.ucla.edu Eduardo Schwartz, University of California, Los Angeles, Anderson School of Management, USA, eschwart@anderson.ucla.edu
 
Suggested Citation
Bhagwan Chowdhry and Eduardo Schwartz (2016), "How Should Firms Hedge Market Risk?", Critical Finance Review: Vol. 5: No. 2, pp 399-415. http://dx.doi.org/10.1561/104.00000023

Published: 21 Dec 2016
© 2016 B. Chowdhry and E. Schwartz
 
Subjects
 
Keywords
G30
Finance
 

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In this article:
1. Introduction
2. The Model
3. Numerical Simulations
4. Continuous-Time Hedging
5. Discussion
6. Conclusion
Appendix: Proof of Theorem 1
References

Abstract

Consider a firm whose stock returns are affected by market returns and an idiosyncratic market-orthogonal factor. The level of the firm’s cash flows depends on the level of the market and the level of the idiosyncratic factor multiplicatively because of compounding. Although a large hedge against the market index minimizes the variance of cash flows, such a hedge does not minimize the costs of financial distress associated with low cash flow realizations below a debt threshold. A hedge ratio based on asset-rate-of-return regression estimates is then incorrect. This holds even in continuous time and with dynamic hedging policies. Our paper provides a simple heuristic for corporations wishing to hedge out the adverse consequences of market risk.

DOI:10.1561/104.00000023