COMPARING THE EFFECTS OF NEUTRAL AND NON-NEUTRAL SHOCKS ON CORPORATE HEDGING STRATEGY: AN EMPIRICAL ANALYSIS

Abstract

This paper examines the impact of the mechanism linking a firm's internal funds to its return on investment on its optimal investment, debt, and hedging strategy. We compare two models of corporate hedging, namely the Investment Opportunity (IO) model and the Technical Change (TC) model, to show how they differ in their empirical implications. In the IO model, shocks to cash flow are assumed to be related to neutral (multiplicative) shocks to the investment return, whereas in the TC model, shocks to cash flow are linked to non-neutral (non-multiplicative) shocks to the investment technology. We obtain general solutions for hedging with both mechanisms, but as they do not allow for a precise identification of the effects of the relevant parameters on hedging, debt, and investment, we derive approximated analytical solutions for hedging to compare the two models. Our analysis shows that the optimal investment, debt, and hedging strategies can be strongly dependent on the mechanism linking a firm's internal funds to its return on investment. Moreover, the two models can be distinguished by observing the extent of hedging for equal values of the relevant parameters and the correlation between investment and debt in a period of technological change. Finally, we simulate the effects of a productivity shock on the two models to illustrate how they react to the same shock. Our findings suggest that the correlation between investment and debt is informative about the way the risk associated with the investment return is hedged through derivative financial instruments. Our study provides valuable insights for firms in determining their optimal hedging strategy, investment, and debt decisions under different mechanisms of corporate hedging.