The interaction of risk management tools: Financial hedging, corporate diversification and liquidity

Abstract

Abstract What kind of firm benefits more from financial hedging, the focused or diversified? In fact, the benefit of financial hedging depends on diversification policies. By analyzing the interaction between financial hedging and corporate diversification in a theoretical model for a financially constrained firm, we find that focused firms have relatively higher marginal value of hedging in general static environment. However, dynamic analysis results show that an important synergy between financial hedging and diversification would reverse this result. Exercising corporate diversification policies has direct negative effect on liquidity and operating risk, thereby increasing the marginal value of financial hedging. As a result, it is possible that their relationship is complementary in a dynamic environment since these tools increase firm value in different channels. This suggests that firms could use financial hedging in the process of diversification if it is possible. Our findings also emphasize the importance of risk management capabilities which is hardly observable but contributes much to firm value.