Hedging, financing, and investment decisions: Theory and empirical tests

In this paper we theoretically and empirically examine the interaction between hedging, financing, and investment decisions. A simple equilibrium model with costly financial distress suggests that as firms become more efficient at risky investments vis a vis low risk investments, they will borrow less, invest more in risky assets, and hedge more. The model also predicts a positive relationship between hedging and leverage - a result consistent with debt capacity arguments. We test the model empirically using a simultaneous equations framework to investigate the determinants of firm-level hedging, financing and investing decisions. The results strongly support the hypothesis that the hedging, financing and investment decisions are jointly determined. In addition, we find strong support for the central hypothesis that firms more efficient investing in risky technologies more aggressively hedge and use less debt financing in order to maximize their comparative advantage.