Hedging and Financing Decisions: A SIMULTANEOUS EQUATIONS MODEL

The spectacular increase in the use of derivatives have led regulators, practitioners and academics to become increasingly concerned about why fi rms use these hedging instruments. Several recent theories suggest that hedging is a value-increasing strategy for the fi rm (Smith and Stulz, 1985; Bessembinder, 1991; Froot et al., 1993). Most of these theories rely on the introduction of some frictions (e.g., taxes, transaction costs, bankruptcy costs) into Modigliani and Miller Model (1958). An increasing number of empirical studies have been performed to investigate these theories. Previous empirical research have shown that corporate hedging is related to taxes, fi nancial distress costs, underinvestment costs, dividend, liquidity and fi rm size. These studies consider the fi nancing decision as exogenous. In other words, the corporate hedging decision is made after having chosen the leverage. However, in reality, hedging and fi nancing decisions are more likely to be endogenous. Indeed, Stulz (1996), Ross (1996) and Leland (1998) show that corporate hedging decisions can be made to increase the debt capacity. Accordingly, the hedging/leverage causality can go both ways: hedging can lead to increased debt capacity, and higher leverage can increase the incentive to hedge. The aim of this paper is to examine whether the hedging and fi nancing decisions are jointly determined. We consider the endogeneity problem and test empirically the interaction between these two fi nancial decisions using a simultaneous equations model. To our knowledge this is the fi rst paper to empirically test the endogenous determination of hedging and fi nancing decisions over a sample of French fi rms.