How Should Firms Hedge Market Risk?∗

Consider a firm whose stock returns are affected by market returns and an idiosyncratic market-orthogonal factor. The level of the firm’s cash flows depends on the level of the market and the level of the idiosyncratic factor multiplicatively because of compounding. Although a large hedge against the market index minimizes the variance of cash flows, such a hedge does not minimize the costs of financial distress associated with low cash flow realizations below a debt threshold. A hedge ratio based on asset-rate-of-return regression estimates is then incorrect. This holds even in continuous time and with dynamic hedging policies. Our paper provides a simple heuristic for corporations wishing to hedge out the adverse consequences of market risk. ∗UCLA Anderson School. Email all correspondence to [email protected]. We thank Jeremy Stein, René Stulz (who also told us about Fischer Black’s critique), and Ivo Welch for many insightful conversations. We also thank seminar participants at UCLA Anderson brown-bag seminar series and at the UCLA-Lugano Finance Conference. We thank anonymous referees for many useful comments, and are deeply grateful to one who helped provide the analytical proof for the main result in the paper.