Agency Conflicts and Risk Management

30 Pages Posted: 30 Aug 2001

See all articles by Erwan Morellec

Erwan Morellec

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Clifford W. Smith

Simon Graduate School of Business, University of Rochester

Date Written: June 2005

Abstract

This paper analyzes the relation between agency conflicts and risk management in a contingent claims model of the firm. In contrast to previous contributions, our analysis incorporates not only stockholder-debtholder conflicts but also manager--stockholder conflicts. We show that the costs of both underinvestment and overinvestment are essential in determining the firm's hedging policy. In particular, firms that derive more of their value from assets in place (lower market-to-book ratios), although having lower costs of underinvestment, generally display larger costs of overinvestment. Thus, they may be more likely to hedge to control these overinvestment incentives. Our analysis demonstrates that the relation between risk management and agency conflicts is more complex than prior discussions have recognized. It also provides a rationale for the recent findings of Bartram, Brown, and Fehle (2004) and suggests reinterpretation of some of the empirical evidence on corporate risk management.

Keywords: Debt Financing, Hedging, Contingent Claims Analysis

JEL Classification: G12, G31, G32

Suggested Citation

Morellec, Erwan and Smith, Clifford W., Agency Conflicts and Risk Management (June 2005). Simon School, University of Rochester, Research Paper Series. Available at SSRN: https://ssrn.com/abstract=281537 or http://dx.doi.org/10.2139/ssrn.281537

Erwan Morellec (Contact Author)

Ecole Polytechnique Fédérale de Lausanne ( email )

College of Management
Extranef Quartier UNIL-Dorigny
1015 Lausanne, CH-1015
Switzerland

HOME PAGE: http://sfi.epfl.ch/

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Clifford W. Smith

Simon Graduate School of Business, University of Rochester ( email )

Carol Simon Hall 3-202C
Rochester, NY 14627
United States
585-275-3217 (Phone)
585-442-6323 (Fax)

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