8.6 Market Imperfections and the Hedging Decision
The decision of whether and how much to hedge must be made on a case-by-case basis. Although the need to hedge is greater for smaller, less-diversified, and riskier firms, the costs of hedging also are greater for these firms. For example, there are large economies of scale in direct bankruptcy costs, so small firms experience larger direct costs as a percent of assets than large firms do. Unfortunately for small firms, there are also large economies of scale in the costs of most financial hedges. Bid-ask spreads on currency forward, option, and swap contracts traded through commercial or investment banks are much narrower for larger transactions, so firms attempting to hedge small amounts can face relatively large percentage transaction costs from their bankers. Similarly, large firms receive volume discounts and smaller percentage fees when hedging with currency futures, options, or other exchange-traded derivatives. These tradeoffs are examined in depth in the next several chapters.