In this paper, we provide new and concrete, elements for pricing and hedging Basis Risk. We consider the problem of an agent paying a derivative written on a risky asset V on which trading is not possible, not allowed or costly. For example, for liquidity reasons, an investor can sell an option on a stock and prefer to hedge with the associated index, or in the commodities market hedge with Fioul Oil 1% an option on Fioul Oil Straight Run 0,5%. In all these cases, one considers a more liquid asset S which is highly correlated with V and then price and hedge investing in S and cash only.
Various studies document the existence of co-movements in liquidity across securities (e.g., Chordia et al. (2000), Hasbrouck and Seppi (2001), Huberman and Halka (2001) for stocks and Chordia et al. (2005) for bonds and stocks). This phenomenon has important implications for asset pricing (see Amihud et al. (2005) for a survey) but its causes are not well understood. One possibility is that financing constraints bind liquidity providers in different securities at the same time and constitute thereby a systematic liquidity factor. This mechanism is formalized, for instance, by Brunnemeier and Pedersen (2007) and has received empirical support for NYSE stocks (see for instance, Coughenour and Saad (2004) or Comerton-Forde et al.(2010)).
The recent collapse of debt financing has also greatly affected the franchising industry. In fact, the issue of franchisees obtaining financing to invest in a franchise outlet has always been a major concern for participants in the industry. For example, being highly leveraged may considerably undermine the incentives for franchisees that are at the core of the franchising idea. This is even explicitly acknowledged in many franchise chains where the franchisor puts explicit lower bounds on the capital that a franchisee must have. At the same time, the inability of franchisees to raise their own capital may also considerably constrain the ability of franchise chains to expand in times of tight credit. Despite the central nature of financing arrangements in franchising, this issue has not been studied either in the theoretical or empirical literature.
In this paper, we develop a simple theoretical model with financially constrained franchisees where franchisee effort and the profitability of franchised outlets will depend on how much collateral a franchisee is able to put up. If the franchisor is not able to find a potential franchisee with sufficient collateralizable assets so that the franchisee will exert more effort than a manager, a company owned outlet will generate higher profits. Based on this theory, we can test the hypothesis that financial constraints have a significant impact on the franchising decision on the basis of macroeconomic data.
