Changing Horses and Hedging

This paper analyzes the interaction between switching investments and hedging. First, the paper shows that hedging economic risk is not optimal in a world with financial distress costs. We assume that financial distress costs are a declining convex function in the level of financial reserves. These reserves include the market value of outstanding hedging contracts, but not the future cash flow prospects from real activities of the firm because these are highly uncertain. As consequence, very long-term hedging contracts would protect the firm against economic risk, but generate high expected distress costs because the hedging contracts might have very low, negative values. This explain why firms hedge only for rather short periods of time