Do Firms Hedge in Response to Tax Incentives?

TLDR

Corporate hedging is incentivized by two tax benefits: increased debt capacity and interest tax deductions, and reduced expected tax liability when the tax function is convex. The study tests whether these tax incentives influence the extent of corporate derivative hedging. The authors employ an explicit measure of tax function convexity to assess firms’ hedging behavior. They find no evidence that firms hedge in response to tax convexity, but demonstrate that hedging raises debt capacity (average tax benefits 1.1% of firm value) and is driven by expected financial distress costs and firm size.

Abstract

ABSTRACT There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.