A Strategic Approach to Hedging and Contracting

This paper provides a new rationale for hedging that is based, in part, on noncompetitive behavior in product markets. We identify a set of conditions which imply that a firm may want to hedge. Empirically, these conditions are not inconsistent with what is observed in the market place. The conditions are: (i) firms have some market power in their product market, (ii) firms have limited liability, and (iii) firms can contract to sell their output at a specified price before all factors which can affect their profitability are known. For some parameter specifications, however, our model predicts that firms will not want to hedge. This result is important because although a large fraction of firms do hedge their cash flows, a substantial number of firms do not.