Capital Structure and Hedging Demand with Incomplete Markets

Abstract We develop a general equilibrium model with production and incomplete markets. Firms optimally design their capital structure to cater to investors’ hedging needs. Depending on the heterogeneity of such needs, equilibrium may feature either complete financial market segmentation or only partial segmentation. Firms respond to greater hedging needs by issuing more debt and allocating most of the proceeds to shareholders. How much more debt depends on the availability of competing risk-sharing instruments. When the capital structure is jointly shaped by hedging demand and agency (asset substitution), the greater risk induced by asymmetric information has countervailing effects on debt: debt is reduced to nudge shareholders into choosing lower risk; however, the greater risk in production affects the state prices and calls for more debt.