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A Signaling Theory of Derivatives-Based Hedging

We model a commodity producing firm with private information about future volume and whose low realized cash flows cause it costly financial distress. A firm's first-best strategy is to sell forward all future production, avoiding any price risk. Low-volume firms, however, have an incentive to mimic, which in equilibrium distorts the hedging strategy of high-volume firms. Under certain conditions, high-types hedge more than their own production volume in equilibrium. Alternatively, equilibrium sometimes entails that high-types hedge less than low-types. When allowing firms to use multiple types of derivatives, we show that high-types use both options and forwards, while low-types only use forwards. The model suggests that heterogeneous and prima facie inefficient hedging policies may be due to signaling and not speculation or risk shifting.