Funding Risk and Hedge Valuation
Posted: 2 Jul 1998
Date Written: Undated
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: Suggested Citation