The joint determination of capital structure and investment risk is examined. Optimal capital structure reflects both the tax advantages of debt less default costs (Modigliani-Miller), and the agency costs resulting from asset substitution (Jensen-Meckling). Agency costs restrict leverage and debt maturity and increase yield spreads, but their importance is relatively small for the range of environments considered. Risk management

This paper studies the hedging policies of oil and gas producers between 1992 and 1994. My evidence shows that the extent of hedging is related to financing costs. In particular, companies with greater financial leverage manage price risks more extensively. My evidence also shows that the likelihood of hedging is related to economies of scale in hedging costs and to the basis risk associated with hedging instruments. Larger companies and companies whose production is located primarily in regions where prices have a high correlation with the prices on which exchangetraded derivatives are based are more likely to manage risks. DESPITE THE PREVALENCE OF CORPORATE RISK MANAGEMENT and the effort that has been devoted to developing theoretical rationales for hedging, there are no widely accepted explanations for risk management as a corporate policy. Important questions remain regarding the determinants of the extent to which a company hedges, the impact of risk management on a firm’s value, and the interaction between a firm’s hedging policy and its other policy decisions. To address some of these questions, I examine the risk management activities of 100 oil and gas producers for 1992 to 1994. In particular, I investigate whether the fraction of production an oil and gas producer hedges against price fluctuations is related to its financing policy, tax status, compensation policy, ownership structure, and operating characteristics. I document a wide variation in hedging policies among oil and gas producers. My tests find that this variation is associated with several differences in the firms ’ characteristics. The fraction of production hedged is positively related to the differences in financial leverage, measured as the ratio of total debt to total assets, and it is greater for oil and gas producers

There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.

Previous research offers little large-sample evidence on the magnitude of non-financial firms ' risk exposure hedged by financial derivatives. In a sample of 234 large non-financial corporations that use derivatives, we find that if the median firm simultaneously experiences a three standard deviation change in interest rates, currency exchange rates, and commodity prices, it will collect $15 million of cash from its entire derivatives portfolio and that the entire derivatives portfolio will rise in value by $31 million. These dollar amounts are modest relative to firm size, operating cash flows, investing cash flows and other firm benchmarks. The findings raise questions about the role of derivatives securities held by non-financial firms.

This paper addresses the question of how an institution might optimally manage the market risk of a given exposure. We provide an analytical approach to optimal risk management under the assumption that the institution wishes to minimize its Value-at-Risk (VaR) using options, and that the underlying exposure follows a geometric Brownian. The optimal solution specifies the VaR-minimizing level of moneyness of the option as a function of the asset's distribution, the risk-free rate, and the VaR hedging period. We find that the optimal strike of the put is independent of the level of expense the institution is willing to incur for its hedging program. The costs associated with a suboptimal choice of exercise price, in terms of either the increased VaR for a fixed hedging cost or the increased cost to achieve a given VaR, are economically significant. Comparative static results show that the optimal strike price of these options is increasing in the asset's drift, decreasing in its volatil...

This paper extends the investigation of the effect of managerial motives on hedging policy. I utilize a proxy variable that incorporates CEO incentives to increase risk versus stock price. The variable is directly measured using the characteristics of CEO portfolios of stock and option holdings. Furthermore, CEO risk-taking incentives are modeled as a choice variable to eliminate the simultaneity bias of modeling risk-taking incentives as an exogenous variable. CEO risk-taking incentives are negatively related to net derivative holdings for a large cross-sectional sample of firms. This effect is only weakly apparent in one-stage models of risk management. If modeled as a simultaneous system of equations, a strong negative link between CEO risk-taking incentives and the amount of derivative holdings exists. This result is consistent with the notion that derivatives are used for hedging purposes. Both the characteristics of stock and option holdings are important in determining cross-sectional differences in corporate derivative holdings.

This paper examines whether firms are hedging or timing the market when selecting the interest rate exposure of their new debt issuances. I use a more accurate measure of the interest rate exposure chosen by firms by combining the initial exposure of newly issued debt securities with their use of interest rate swaps. The results indicate that the final interest rate exposure is largely driven by the slope of the yield curve at the time the debt is issued. These results suggest that interest rate risk management practices are primarily driven by speculation or myopia, not hedging considerations.

This paper examines risk management strategies for natural gas firms that face multiple risks (e.g., price and volume risk) and have a variety of financial and non-financial tools available to manage those risks. Natural gas firms' risk exposures to price and volume risk were changing significantly during the sample period due to a unique series of regulatory changes, including price deregulation. Natural gas firms used a combination of gas storage, cash holdings, line-ofbusiness and geographic diversification to hedge increasing volume risk and changing exposure to price risk. The firms extensively use commodity derivatives when available. Holding cash and storing gas are complementary strategies that are used by similar types of firms. While the use of derivatives and storing gas are related, firms appear to use derivatives to manage price risk and gas storage to manage volume risk. Finally, the various strategies are effective. Natural gas pipeline firms that pursue financial or operational hedging activities have smaller and less variable sensitivities to price changes than firms that do not, especially post-deregulation.

This paper examines the use of credit derivatives by US bank holding companies from 1999 to 2003 with assets in excess of one billion dollars. Using the Federal Reserve Bank of Chicago Bank Holding Company Database, we find that in 2003 only 19 large banks out of 345 use credit derivatives. Though few banks use credit derivatives, the assets of these banks represent on average two thirds of the assets of bank holding companies with assets in excess of $1 billion. Few banks are net buyers of credit protection and disclose using credit derivatives to hedge loans. Banks are more likely to be net protection buyers if they engage in asset securitization, originate foreign loans, and have lower capital ratios. The likelihood of a bank being a net protection buyer is positively related to the percentage of commercial and industrial loans in a bank’s loan portfolio and negatively or not related to other types of bank loans. The use of credit derivatives by banks is limited because adverse selection and moral hazard problems make the market for credit derivatives illiquid for the typical credit exposures of banks.

We show that, under standard assumptions about technology and production costs, financially constrained firms may have incentives to speculate as well as to hedge. Within the context of an industry equilibrium, we show that a firm’s risk management choice depends on the choices of its competitors, and in equilibrium even identical firms may choose di¤erent hedging strategies. Industry characteristics, such as the number of firms in the industry, the size of the market, the elasticity of demand, and marginal production costs determine how many firms hedge and how many …rms do not hedge in equilibrium. Even if hedging strategies are continuous, the typical equilibria are corner solutions, in which some …rms remain completely unhedged and others hedge to the maximum possible extent. Our results are consistent with several stylized facts documented in surveys and recent empirical work, and generate new testable hypotheses concerning the determinants of hedging strategies in an industry context.