DP16968 Capital Structure and Hedging Demand with Incomplete Markets
In this paper we study the role played by hedging demand in shaping firms' capital structure. We develop and study a general equilibrium model with production and incomplete markets where households differ in their risk-sharing needs. Value-maximizing firms cater to these different needs when choosing their leverage, their size, and possibly the risk profile of their production technology. We find that as the demand for hedging increases, firms issue more debt and destine only part of the greater proceeds to investment - the remainder going to shareholders. How much more debt, depends on the availability of competing risk-sharing instruments, such as (government-issued) risk-free debt and derivatives. When the capital structure is jointly shaped by hedging demand and agency - in the form of an asset-substitution problem - the greater risk induced by asymmetric information has countervailing effects on debt: on the one hand, debt is reduced to nudge shareholders into choosing lower risk. This is the standard asset substitution effect. On the other hand, however, the greater risk in production affects the state prices and calls for more debt.