Does Hedging Aggravate or Alleviate Agency Problems? A Managerial Theory of Risk Management

Abstract

This paper investigates how corporate risk management policy and managerial compensation contracts are jointly determined when hedging policy can be a source of agency problems. The optimal hedging policy and stock-based compensation contract are characterized in terms of the firm's abandonment (liquidation) value, its profitability, and the extent of its risk exposure. The basic tradeoff is between the efficiency of managerial effort and that of the firm?s abandonment option. The recognition of the loss of abandonment option value as an economic cost of hedging has implications for why firms hedge less long term exposure, why hedging is necessary for incentive purposes even when compensation contracts are allowed to be dependent on the variables being hedged, why firms seem to be more concerned with the downside risk and how the downside risk should be measured, and why disclosing the market value of hedging instruments can undermine hedging. The model yields joint testable predictions for hedging policy and the form of compensation contracts. The paper also identifies conditions under which welfare will be improved if hedging can be prohibited.

JEL Classification: D82, G30, J33