A Signaling Theory of Derivatives-Based Hedging

Abstract

This paper argues that hedging with derivatives can be an effective way for firms to overcome frictions associated with informational asymmetries. We develop a simple model where firms face financial price risk and, in addition, are privately informed about true output (e.g., expected amount of commodity to be produced). For a high-output firm needing to raise external funds from uninformed investors, hedging not only reduces expected financial distress costs but also credibly conveys that the firm is high-output, which minimizes financing costs and facilitates investment. Hedging helps in overcoming the informational asymmetry because it is costly for low-output firms to mimic, since mimicking would entail exposure to the basis risk associated with output mismatch. We show that in some cases signaling incentives cause high-output firms to depart from the hedging strategy that minimizes expected costs of financial distress. In such cases, high-output firms generally tend to over-hedge relative to their natural exposure. Finally, we show that in the presence of signaling concerns only high-output firms trade non-linear derivatives.

Keywords: hedging, risk management, derivatives, signaling

JEL Classification: G32, D82