This seminar paper deals with three main hedging policies. It is based on the Smith and Stulz (1985) paper "the determinants of firms' hedging policies. Furthermore their results are compared with other scientific papers. At the end, one should be able to get a basic knowledge about hedging and how taxes, debt and managerial behavior can influence different policies.
Table of Contents
I. Introduction
II. Taxes
III. Debt
IV. Managerial Compensation and Risk Aversion
V. Conclusion
Research Objectives and Core Topics
This work aims to explain the fundamental determinants of firms' hedging policies by synthesizing the milestone research of Smith and Stulz (1985) and contrasting it with subsequent academic literature. The core objective is to analyze how corporate hedging strategies are shaped by tax considerations, debt financing structures, and managerial incentives.
- Tax efficiency and the impact of hedging on firm value
- Hedging strategies in the context of debt and bankruptcy costs
- The relationship between managerial risk aversion and wage compensation structures
- The influence of corporate payout structures on hedging decisions
- Integration of hedging policies into broader firm strategy
Excerpt from the Book
II. Taxes
Smith and Stulz (1985) are one of the first researchers who concern taxes in hedging decisions. They form a model to describe whether financial hedging is good or bad for companies at all. In their model they defined certain assumptions. On the one hand they argue that the marginal tax value increases with the pretax return of a firm. The main argument of their work is that the after-tax value and pretax value of a firm is given by a concave function. This model tries to show the common tax systems of most countries. The more a company earns the higher is the amount of tax that it has to pay for. The usage of derivatives has the possibility to decrease liabilities of taxes as it is shown in figure 1.
Figure 1 is divided into two parts. The upper part shows the relation between pre-tax firm value on the x-axes and corporate tax liability on the y-axes. As it is explained above we can see a linear relation in this graph (without hedging!). The lower part of figure 1 indicates the relation between pre-tax value and post-tax value. Also this relation is linear without the use of derivatives.
Summary of Chapters
I. Introduction: This chapter introduces hedging as a corporate stabilization instrument and establishes the Smith and Stulz (1985) paper as the foundational framework for analyzing taxes, debt, and managerial behavior.
II. Taxes: This section explores how hedging can be used to decrease tax liabilities, detailing the concave relationship between pre-tax and after-tax firm value as proposed by Smith and Stulz.
III. Debt: This chapter examines the role of hedging in managing bankruptcy costs and the influence of external debt on a firm's incentive to utilize derivative instruments.
IV. Managerial Compensation and Risk Aversion: This part analyzes how management's risk preferences and specific wage compensation structures impact corporate hedging decisions and the realization of positive NPV projects.
V. Conclusion: The concluding chapter synthesizes the findings across the three main areas, confirming that while hedging approaches vary, they collectively contribute to increasing a firm's after-tax value.
Keywords
Hedging, Derivatives, Corporate Tax, Bankruptcy Costs, Managerial Compensation, Risk Aversion, Debt Financing, Firm Value, Payout Structure, NPV, Financial Distress, Leverage, Wage Contracts, Tax Shield, Corporate Finance
Frequently Asked Questions
What is the primary focus of this work?
This essay explores the primary determinants of corporate hedging policies, specifically analyzing how tax strategies, debt obligations, and management incentives influence a firm's decision to hedge.
What are the central thematic fields covered in this paper?
The central themes are corporate risk management, the impact of tax systems on firm value, the relationship between debt and financial distress costs, and the role of managerial behavior in strategic decision-making.
What is the core objective of the research?
The objective is to synthesize key scientific models—most notably Smith and Stulz (1985)—to explain why firms hedge and how these strategies impact overall corporate wealth.
Which scientific methodology is primarily applied?
The work utilizes a literature-based comparative analysis, examining foundational financial models and contrasting them with subsequent empirical research and simulations.
What topics are discussed in the main body of the text?
The main body treats the effects of hedging on tax liabilities, the interaction between external debt and bankruptcy risk, and how different managerial compensation structures, such as concave or convex payout schemes, drive risk aversion.
Which keywords best characterize the work?
Key terms include Hedging, Derivatives, Firm Value, Managerial Compensation, Tax Shield, Debt Financing, and Corporate Risk Management.
How do tax structures influence the necessity of hedging?
According to the model, firms operating under concave tax structures can improve their after-tax value through hedging, whereas other accounting methods, such as net operating loss carryforwards, might reduce the marginal benefit of hedging.
What impact does managerial risk aversion have on corporate hedging?
Risk-averse managers tend to hedge to protect their own wealth and the firm's stability; however, if compensation structures are skewed (e.g., convex structures), managers might engage in excessive speculation rather than value-maximizing hedging.
Do managers always prioritize firm value maximization?
Not necessarily. The paper notes that managers might prioritize their own wealth maximization, potentially using derivatives to engage in speculative projects to increase NPV volatility rather than simply reducing risk.
- Arbeit zitieren
- BSc Oliver Baumgartner (Autor:in), 2012, The Determinants of Firms’ Hedging Policies: an Explanatory Summary of Different Scientific Papers, München, GRIN Verlag, https://www.grin.com/document/211890
