Stephen D. Smith and Larry D. Wall
Working Paper 2005-30
December 2005
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This paper provides a theory of debt and hedging based on human capital. We distinguish human capital from physical capital in two ways: (1) human capital is inalienable and can exercise a one-sided option to leave the firm, and (2) human capital is not perfectly replaceable. We show that a firm may reach the first best solution while issuing debt or equity to outsiders provided that either the insiders receive a senior claim or that the firm hedges. We then show that, given asymmetric information concerning costs, the only viable solution has the firm issuing debt to outsiders and hedging.
JEL classification: G32
Key words: hedging, human capital, capital structure
The authors thank participants at the risk management and insurance seminar at Georgia State University for valuable comments. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.
Please address questions regarding content to Stephen D. Smith, Federal Reserve Bank of Atlanta and Georgia State University, Room 1234, RCB Building, Atlanta, GA 30301, 404-651-1236, sdsmith@gsu.edu, and Larry D. Wall, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, GA 30309, 404-498-8937, larry.wall@atl.frb.org.