The Agency Problems of Hedging and Earnings Management
48 Pages Posted: 17 Oct 2007
This paper uses a principal-agent model to study the interaction between hedging and earnings management. The key assumption is that hedging makes earnings management more costly.
In this model, hedging is efficient if the hedging decision is contractible, since it reduces both the risk premium and the equilibrium amount of earnings management. However, when the hedging decision is not contractible, a strategy of discouraging hedging but allowing earnings management may be optimal, since encouraging hedging may require a more costly compensation scheme to compensate the agent for reduced earnings management.
Here, encouraging truth-telling is costly and inefficient when there is no opportunity to hedge. However, with hedging, the cost of motivating truth-telling can be reduced. In some situations, a strategy of motivating hedging and truth-telling is optimal.
Hedging and earnings management are strategic substitutes in this paper, which is consistent with existing empirical evidence. This study also provides an alternative explanation for that evidence.
Keywords: hedging, earnings management, substitute
JEL Classification: D82, M41, M43, J41
Suggested Citation: Suggested Citation