Suppose an oil firm has a project that yields either 60, 80, or 100 next period with equal probability and requires an investment of 70 today. The firm has no internal funds and can only get external financing through credit markets. Credit markets are competitive. If the firm defaults, there will be legal costs of 10. 

a. Should the firm hedge, if hedging has no costs? 

b. If the firm should hedge what is the maximum cost per unit of hedging that the firm should be willing to pay?

Answer rating: 100% (QA)

a If hedging has no costs the firm should hedge its investment By hedging the firm can protect itsel... View the full answer