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Hedging and debt overhang: a conceptual note

Jacques A. Schnabel (School of Business and Economics, Wilfrid Laurier University, Waterloo, Canada)

Journal of Risk Finance

ISSN: 1526-5943

Article publication date: 16 March 2015

Abstract

Purpose

This paper aims to examine the nexus between hedging, which reduces the volatility of corporate assets, and the anomaly of debt overhang, whereby corporate management is motivated to reject positive net present value (NPV) projects. The question of whether hedging ameliorates or aggravates debt overhang is addressed.

Design/methodology/approach

The Black–Scholes isomorphism between common shares and call options is exploited to determine the allocation of a project’s NPV between debt- and stock-holders. The effect of hedging on this NPV-partitioning is then gauged to determine the resulting likelihood of debt overhang.

Findings

If the volatility of corporate assets is below a critical maximum, hedging ameliorates debt overhang consistent with extant theoretical research. However, above that critical value of volatility, hedging aggravates debt overhang.

Originality/value

The novel result of this note, namely, hedging may exacerbate debt overhang, is demonstrated both analytically and intuitively. The latter is explained by allusion to a second agency-theoretic conflict between debt- versus stock-holders, namely, risk shifting. The disparate effects of hedging on debt overhang imply a non-monotonic relationship between metrics for these two variables, which is a phenomenon that extant empirical studies have failed to take into account.

Keywords

Citation

Schnabel, J.A. (2015), "Hedging and debt overhang: a conceptual note", Journal of Risk Finance, Vol. 16 No. 2, pp. 164-169. https://doi.org/10.1108/JRF-10-2014-0140

Publisher

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Emerald Group Publishing Limited

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