Hedging, Leverage, and Primitive Risk

Abstract

Only in the last decade have nonfinancial firms begun to develop effective procedures for hedging the increased volatility of exchange rates, interest rates, and commodity prices. We report the first empirical evidence on hedging, leverage, and other firm characteristics from the 1990s, subsequent to the rapid growth of hedging. We unravel a previous puzzle in corporate finance, showing a significant positive relationship between hedging and leverage when we control for primitive risk exposures. Hedging and leverage policies are interrelated because both affect expected costs of financial distress and agency costs. We construct a direct measure of the expected costs of financial distress and find some evidence that hedging mitigates the effects of leverage.