Hedging, Cash Flows, and Firm Value: Evidence of an Indirect Effect

This paper extends and tests the predictions of Froot, Scharfstein, and Stein's (1993) model of the relation between hedging, cash flows, and firm value. Specifically, we model the impact of derivatives hedging on firm value both directly and also indirectly through its effect on cash flow volatility. We test the model's predictions using a sample of publicly traded life insurers who report detailed information on both the extent and purpose of derivatives use. We find that both derivatives hedging and cash flow volatility are negatively related to firm value. However, consistent with our theoretical predictions, we find that hedging mitigates the negative value effect of cash flow volatility.