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managers might hedge to ensure sufficient internal funds are available for their pet
projects. Alternatively, these managers might be entrenched and bankruptcy might be the
only mechanism through which they can be replaced. Hedging a primary risk, hence,
delays the inevitable bankruptcy, and allows managers to prolong their tenure. Or,
managements in such firms overestimate their own abilities and believe that the firm’s
stock is undervalued. Instead of issuing equity to finance growth, they rely on debt
financing although their firms are overlevered. Since the firm’s lenders do not share the
managers’ optimism, they require the firm hedges to mitigate the risk of their
investment. 201 These can explain the apparent discount for hedging primary risk.
Considering the premium for hedging secondary risk, Brown [2001] suggests that firms
hedge secondary risks as a disciplining mechanism. Entering into actual hedge positions
ensures that line managers are using real market data, as opposed to their own preferred
estimates, for budgeting and planning. Since firms with good corporate governance are
more likely to have such internal auditing structures in place, hedging secondary risks and
good governance are positively correlated. Alternatively, good managers might hedge
secondary risks to reduce the noise in the firm’s earnings to signal their superior abilities to
the market, as suggested by DeMarzo and Duffie [1995].
Lookman [2005b] also compares the estimated increase in firm value predicted by the
structural model suggested by Leland [1998] with the empirical estimate given by Graham
and Rogers [2002]. This latter estimates for a typical non-financial firm exposed to foreign
exchange and interest rate risks that hedging – to the extent observed in practice –
increases firm value by 1.1%. The calibrated structural model, on the other hand, estimates
the size of hedge position that increases firm value by 1.1% as a result of increased debt
tax shields to be 400% of annual revenues – an order of magnitude larger than that
observed in practice. The reason for hedging being so ineffective in increasing debt
capacity, according to Lookman [2005b], lies in the fact that to increase optimal leverage,
a firm must hedge its value. For a typical firm, shocks to earnings are persistent and firm
value is several multiples of annual earnings. Therefore, to hedge its value, the firm must
hedge its earnings for several years ahead. However, firms typically only enter into
hedging contracts to hedge the next year’s earnings, which decreases firm value volatility
201 Chidambaran et al. [2001] provide a numerical example illustrating how managers can destroy firm value
by issuing debt bundled with a hedge, rather than issuing equity instead.
197