An important charcteristic of widely held corporations is that, their owners are stockholders or bondholders who can hold diversified portfolios to secure themselves for future economic risks. So tat, most of the litreture focusing on the risk averse producers to explain hedging practises of firms are not relevant for widely held companies.
Hedging policy affects the value of the firm throuh contacting costs, taxes or the impact of hedging policy on its decisions. According to Modigliani and Miller [1958], when operations and investments are not affected, when there is no taxes or cost of financial distress, the value of the firm is unaffected by its financial policy.
According to Mayers/Smith -1982, Smith/Stulz-1985, hedging can increase the value of the firm if it faces a convex tax function. If the marginal tax rates are the increasing function of the firms pre-tax value, then as long as the cost of the hedging is not too high, firms can increase their expected post-tax value if they can reduce the variability of their pre-tax values by hedging. It implies that, when there is a convex tax function, volatility of income provides low tax payments in some periods while it leads to high tax payments in other periods and this situation causes firm to pay more than it would pay on a stable stream of income. Firms will have more incentive to hedge as the convexity of the tax function.
On the other hand, firms have to take the cost of hedging transactions into consideration. Firm can increase its post-tax value by haedging unless costs of hedging transactions do not exceed the benefits. Hedging costs may arise from that firms purchase pre-tax cash flows from investors who receive post-tax cash flows.If investors do not have ...