The Minimum-Variance-Hedge and the Bankruptcy Risk of the Firm, forthcoming in: Review of Financial Economics

In this paper, we analyze the influence of hedging with forward contracts on the firm´s prob-ability of bankruptcy. The minimization of this probability can serve as a substitute for the maximization of shareholders wealth. It is shown that the popular minimum-variance-hedge is generally neither necessary nor sufficient for the minimization of the firm´s probability of bankruptcy. Moreover, our model suggests a correction of the widespread view that a reduc-tion in the variance of the future value of the firm is inevitably accompanied by a reduction in its default risk. We derive an analytical solution for the variance-minimizing hedge ratio of a firm exposed to both input and output price uncertainty that takes into account the issue of correlation. Based on this solution we provide a graphical analysis to prove our claim that there is a fundamental difference between hedging policies focused on bankruptcy risk and those following conventional wisdom even if positive correlation constitutes a “natural” hedge. JEL-Classification