ARE ACQUISITIONS AN OPERATIONAL HEDGE? THE INTERACTION OF FINANCIAL AND OPERATIONAL HEDGING

This paper investigates the substitution of financial and operational hedging choices. Modern risk management can enhance firm value when volatility is costly due to capital market imperfections. Both financial hedging with derivatives and operational hedging can reduce income volatility and, in turn, the potential costs of such volatility. I present a simple model of the tradeoffs between such hedging choices to motivate an empirical investigation into firm behavior. Using a large sample of bank holding companies, I document that acquisitions can provide operational hedging and that this is a substitute for financial hedging. Not only do the majority of acquisitions reduce volatility, the subsequent decrease in financial hedging corresponds to an acquisition’s contribution to operational hedging. Those acquisitions that provide the most operational hedging are followed by the largest declines in financial hedging