Why do risk neutral firms hedge?: A review of the literature

Abstract: According to classical finance theory, a risk neutral firm has no incentives to hedge. We will investigate why firms hedge by starting from the assumptions underlying the Modigliani-Miller propositions. One at a time, we will relax the assumptions and investigate the effect on hedging incentives. Theory and empirical evidence reviewed in this thesis suggest that firms hedge because some of the Modigliani-Miller assumptions do not hold. In particular, to have an increased debt capacity and thereby enabling a larger interest tax shield and the fact that external financing is costly appear to be important reasons why firms hedge.