Financial Constraints, Competition, and
Hedging in Industry Equilibrium
TIM ADAM, SUDIPTO DASGUPTA, and SHERIDAN TITMAN
∗
ABSTRACT
We analyze the hedging decisions of firms, within an equilibrium setting that allows us to examine how
a firm’s hedging choice depends on the hedging choices of its competitors. Within this equilibrium
some firms hedge while others do not, even though all firms are ex ante identical. The fraction of
firms that hedge depends on industry characteristics, such as the number of firms in the industry, the
elasticity of demand, and the convexity of production costs. Consistent with prior empirical findings,
themodelpredictsthatthereismoreheterogeneityinthedecisiontohedgeinthemostcompetitive
industries.
∗
Adam is from the MIT Sloan School of Management, Dasgupta from the Hong Kong University of Science
& Technology (HKUST), and Titman from the University of Texas. We are grateful to Axel Adam-M¨uller,
S¨ohnke Bartram, Nittai Bergman, Dirk Jenter, Peter Mackay, Gordon Phillips, James Vickery, Keith Wong,
and an anonymous referee for valuable suggestions that greatly improved the paper. We would also like to
thank seminar participants at HKUST, MIT, National University of Singapore, Tel Aviv University, University
of Mainz, and the annual meetings of the American, European, and Western Finance Associations for their
comments and discussions. Any remaining errors are our own.
Risks have costs as well as benefits. The costs have been the focus of a growing literature on
corporate risk management and hence are well understood.
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In contrast, the idea that risk
can also be beneficial has been recognized in the real options literature but has largely been
ignored in the risk management literature.
Theobjectiveofthispaperistoanalyzethehedgingdecisionsoffirmsthattakeinto
account both the costs and the benefits of their risk exposures. To do so we develop a model
in the spirit of Froot, Scharfstein, and Stein (1993) (henceforth, FSS). FSS assume that
internal funds are less costly than external funds. Consistent with this view, we consider the
extreme case in which firms must rely solely on internal funds to finance their investments.
In contrast to FSS, however, we model a firm’s output decision explicitly. In particular, we
assume that firms have the flexibility to adjust their output levels in response to realized
production costs after making their investment choices. Within this setting, the volatility of
cash flows, which affect investment and in turn production costs, can benefit firms that have
the flexibility to produce more when costs are low and less when costs are high. We show
that because of this flexibility, a firm’s profit function can be convex in investment, which
provides financially constrained firms an incentive not to hedge.
A further contribution of our model is that it analyzes how these incentives affect firms’
risk management decisions within the context of an industry equilibrium in which the equi-
librium price is determined endogenously. Since the equilibrium output price is a function
of aggregate investment and hedging decisions, a firm’s risk management choice is affected
by the investment/hedging decisions of other firms in the industry. Specifically, firms gain
more from additional investment when other firms in the industry invest less, which implies
1
that a firm has an incentive to make risk management choices that transfer cash flows to
those states in which its competitors are relatively cash constrained. This in turn implies
that an individual firm’s incentive to hedge increases as more firms in the industry choose
not to hedge and vice versa. As a result, an industry equilibrium can exist in which some
firms hedge and others do not, even though all firms are ex ante identical.
The model developed in this paper is related to existing research that explores why
similar firms in the same industry often choose different capital structures. In particular,
our equilibrium analysis is related to Maksimovic and Zechner (1991), who show that ex-
ante identical firms may choose different debt-equity ratios, and De Meza (1986), who shows
that otherwise identical firms may choose different production technologies in an industry
equilibrium. Our model is also closely related to Shleifer and Vishny (1992), who examine
how a firm’s bankruptcy/liquidation costs depend on the financial health of its competitors.
In the Shleifer and Vishny model capital structure choices are interdependent because the
bankruptcy costs of an individual firm are lower if other firms within the same industry are
financially healthy, and compete to buy the assets of failing firms. Similarly, the firms in our
model have an incentive to generate cash flows in those situations in which other industry
participants are financially constrained.
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Our model generates a number of predictions that relate industry characteristics to the
fraction of firms that hedge.
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We find that in equilibrium approximately half of the firms use
derivatives, while the other half do not. This is consistent with empirical studies that show
that on average “hedging” and “not hedging” are equally common in the nonfinancial sector.
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The exact fraction of derivatives users depends on industry characteristics such as the number
2
of firms in the industry (degree of competition), the elasticity of demand, the convexity of
production costs, and market size. For example, our model implies that in industries with
more competitors, steeper industry demand curves, and flatter marginal cost curves, there
is more heterogeneity in firms’ hedging choices, that is, the fraction of firms that hedge in
industry equilibrium moves towards 50% (the point of maximum heterogeneity). In addition,
we find that larger market size results in a larger fraction of firms hedging in equilibrium.
These predictions are consistent with several empirical studies. Allayannis and Weston
(1999), for example, find a positive correlation between mark-ups, which proxy for the degree
of competition in an industry, and the extent of derivatives usage in that industry. G´eczy,
Minton, and Schrand (1997) find that in industries with many firms there is more hetero-
geneity in hedging decisions than in industries with relatively few firms. In addition, the
idea that hedging choices affect product market prices is consistent with Nain (2004), who
documents that output prices are less volatile in industries in which more firms hedge their
foreign exchange rate risks.
The rest of the paper is organized as follows. In Section I, we outline the basic model
and show that given our assumptions a firm’s profit function is convex in investment and
the equilibrium output price. In Section II, we consider the special case of a price-taking
firm and illustrate how the profit function can be convex as well as concave in investment.
Sections III and IV outline the subgame-perfect Nash equilibrium for our two-stage game.
In Section V we discuss the comparative static results and in Section VI we consider several
extensions of the model. Section VII discusses the empirical implications of the model and
Section VIII concludes.
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I. The Model
Consider an industry with n identical firms. At date 1, all firms receive identical but
uncertain cash flows, which they can invest in productive capital that generates returns at
date 2.
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At date 0, firms decide whether or not to hedge their cash flows. If a firm does not
hedge, the amount of funds available for investment at date 1 will be y =¯y + ,where
is a common shock to all firms and E(y)=¯y. If a firm hedges, then the amount of funds
available for investment at date 1 will be y =¯y.
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While firms can hedge at fair terms, we assume that they cannot raise external finance.
Further, we assume that for all values of y, the marginal return to investment is higher than
the opportunity cost of funds, which is normalized to one. This implies that firms will invest
their entire cash flows, that is, k = y,wherek denotes a firm’s investment.
7
The above discussion is summarized in the following timeline of events:
T=0 Firms only know the exogenous distribution of their cash endowments y at T=1, not
the realization. Each firm decides whether or not to hedge their cash flows given the
hedging strategies of all other firms. That is, hedging is determined within a Nash
equilibrium.
T=1 Cash flows are realized, and firms invest all of their cash flows. Each firm observes the
investment decisions of all other firms. Firms then choose their outputs in the context
of a Cournot equilibrium.
T=2 Profits are realized.
4