Funding Risk and Hedge Valuation

Posted: 2 Jul 1998

See all articles by Antonio S. Mello

Antonio S. Mello

University of Wisconsin - Madison - Department of Finance, Investment and Banking

John E. Parsons

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Date Written: Undated

Abstract

This paper shows how liquidity and cash flow timing problems associated with different hedge strategies are related to the firm's value. We show that a policy of fully hedging the firm's value is not optimal. A full hedge lowers the value absolutely because of the enormous funding requirements created early in the life of the hedge, funding requirements that impose a dissipative cost on the firm. We illustrate this with an example in which the value of the fully hedged firm is less than the value of a firm with no hedge at all. We then show that a much smaller hedge succeeds in capturing all of the potential benefits of hedging without imposing significant dissipative costs. The example underscores the fact that the objective of hedging should not be to minimize the risk of the firm per se. The model establishes a parsimonious demand for hedging.

JEL Classification: G13, G32

Suggested Citation

Mello, Antonio S. and Parsons, John E., Funding Risk and Hedge Valuation (Undated). Available at SSRN: https://ssrn.com/abstract=7316

Antonio S. Mello

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States
608-263-3423 (Phone)
608-265-4195 (Fax)

John E. Parsons (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

HOME PAGE: http://www.mit.edu/~jparsons/

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