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Hedging PolÐ"oCÐ"oEs

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An important charcteristic of widely held corporations is that, their owners are stockholders or bondholders who can hold diversified portfolios to secure themselves for future economic risks. So tat, most of the litreture focusing on the risk averse producers to explain hedging practises of firms are not relevant for widely held companies.

Hedging policy affects the value of the firm throuh contacting costs, taxes or the impact of hedging policy on its decisions. According to Modigliani and Miller [1958], when operations and investments are not affected, when there is no taxes or cost of financial distress, the value of the firm is unaffected by its financial policy.

According to Mayers/Smith -1982, Smith/Stulz-1985, hedging can increase the value of the firm if it faces a convex tax function. Ð"of the marginal tax rates are the increasing function of the firms pre-tax value, then as long as the cost of the hedging is not too high, firms can increase their expected post-tax value if they can reduce the variability of their pre-tax values by hedging. Ð"ot implies that, when there is a convex tax function, volatility of income provides low tax payments in some periods while it leads to high tax payments in other periods and this situation causes firm to pay more than it would pay on a stable stream of income. Firms will have more incentive to hedge as the convexity of the tax function.

On the other hand, firms have to take the cost of hedging transactions into consideration. Firm can increase its post-tax value by haedging unless costs of hedging transactions do not exceed the benefits. Hedging costs may arise from that firms purchase pre-tax cash flows from investors who receive post-tax cash flows.Ð"of investors do not have linear tax functions in the payoffs of the hedging instruments, the benefits of hedging to a firm can be offset by an increase in the tax liability of the investors. Because, in this case costs of the hedging instruments would increase accordingly and firms would not be able to benefit from hedging.

Ð"on this context, costs of bankruptcy can also induce widely held firms to hedge. When a firm is close to bankruptcy, there is conflict between firm’s shareholders and bondholders. The wealths of the managers depend to the performance of the firm. Since managers can not sell forward part of their lifetime future wages, they have to hedge. Because of that the home-made hedging by the managers is expensive or difficult, and is risky, managers prefer the firm to hedge instead.

Shareholders can hedge by taking decisions in order to decrease the future value of the firm. By this way, while the ecpected banruptcy costs of the firm decreases, shareholders benefit from this. And shareholders can increase their wealth if they can achieve to persuade potential bondholders that the firm will hedge after bond sale. But since bondholders know that hedging after sale of the firm’s depts contradicts with shareholders benefits, it is hard for the firm to make a credible annauncement about that it will hedge. In the presence of financial distress costs, the firm should minimize the variance of its cashflows.

One of the two possible market forces creating incentives which makes shareholders persue hedging is that a firm can benefit from a reputation for hedging since it increases the price of firm’s new dept. For this to happen, a firm must be borrowing frequently and must be able to avoid bankruptcy. The expected reduction in the bankruptcy costs are higher for smaller firms, so that, smaller firms are more likely to hedge when compared to large firms.

Second market force is that firm can reduce the financial distress costs arising from bond covenants. A firm can hedge to reduce financial distress by reducing the variance of its accounting incomes. Because bond covenants use accounting numbers for defining the states where the firm’s activities are restricted.

Ð"on addition to these, firms can hedge also to decrease the risks imposed on their claimholders. Because the individuals such as firm’s customers, employees, managers are generally unable to diversify risks specific to their claims on the firm and hence they require compansation for the risk they face with. Although firm’s capital stock can reduce the amount of risk imposed to stockholders, it must hedge to reduce risks imposed to other claimholders. Firms can benefit from hedging as long as the costs of hedging does not exceed the expected reduction in compensations.

When decisions are being taken by professional managers, provisions of their contracts can affect their decision in chooisng type of the hedging. Because, to provide incentives for managers in increasing firm’s value, their contracts are prepared in a way to increase managers utility as the value of the firm increases. Distribution of the firm’s payoffs determine the utility of the managers and hedging changes this distribution.

Since hedging can be defined as the acquisition of financial assets which reduce the variability of the firm’s payoffs, the firm is supposed to acquire a hedge portfolio that creats neither outflow at acquisiton nor a cash inflow. Ð"of we assume that is the payoff of the hedge portfolio in in state i, then where N is the amount of shares of asset j purchased and is the payoff of one share of asset “j” in state ” i”.

The manager’s indirect utility function in state i is a function of his wealth at the end of the peroiod in state i ( ). And manager’s wealth is an increasing function of the total value of the firm in state i ( ). Then, where i = 1...S. Because of the indirect utility function of wealth is strictly concave, managers are risk averse, and the fuction showing how a manager maximizes expected utility is as follows;

, where is the probability of state i occurring, subject to the bugdet condition which is , where means the initial price of a share of asset j. By taking first order conditions we can optain the optimal number of shares of each security ( ). for all k and j. This expression states that if all of the financial assets have same return firm is not imposed to any transaction costs because of buying or selling financial assets. The optimal hedging strategy under assumptions that the utility of the managers is



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