Nov 10, 2008

Legitimate reasons to hedge

The best criterion for determining if risks should be hedged: does the hedge increase firm value? From an HBS paper - what are some of the imperfections that make risk management relevant?
  • Costs of financial distress
  • Variability of investment needs such as R&D expense
  • Taxes: progressive or convex tax functions, or diminished value of tax loss carryforwards
  • Transactions costs: can the firm hedge at a lower cost than an individual
  • Asymmetric information flows between managers, owners, and debtholders
  • Poorly diversified managers (if value added by retaining managers > cost of hedging and there is no other contractual way to reduce managers' risk)

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