Hedging in the theory of corporate finance: A reply to our critics

authors: Christopher L Culp, Merton H Miller year: 1995 See in Zotero

Literature Notes

Is a reply to critics of their @culp1995 paper.

MGRM was NOT attempting to hedge based on standard finance risk management models - So-called “pure risk avoidance hedging”. Instead, they were hedging away the absolute spot price risk of the oil, but keeping the exposure to the relative price risk seen in the futures basis (interest + storage costs - convenience yield). Bankruptcy costs/ risk wasn’t very important because of their big (supposed) financial backers.

They were “trading the basis”, they weren’t trying to worry about what would happen with oil prices in the entire market. Instead, they used their hedge to get rid of absolute spot price risk and instead trade on differences in marginal storage costs and convenience yields. This is where they had tacit knowledge giving them a comparative advantage.

MGRM was using a Carry Charge Hedge - Idea from Working’s ag econ papers… add later.