Efficiency or Resiliency? Corporate Choice between FInancial and Operational Hedging

We propose and model that firms face two potential defaults: Financial default on their debt obligations and operational default such as a failure to deliver on obligations to customers. Hence, firms with limitations on outside financing substitute between saving cash for financial hedging to mitigate financial default risk, and spending on operational hedging to mitigate operational default risk. Whereas financial hedging increases in financial leverage, operational hedging declines in leverage. This results in a positive relationship between operational spread (markup) of the firm and its financial leverage or credit risk, which is stronger for firms facing financing constraints. We present empirical evidence supporting the relationship by employing two proxies for operational hedging, viz., inventory and supply chain diversification, exploiting recessions and the global financial crisis as exogenous correlated shocks to operational and credit risks