Hedging and Gambling: Corporate Risk Choice When Informing the Market

CEPR Discussion Paper Series Number 1520

Posted: 21 Apr 1997

See all articles by Francois Degeorge

Francois Degeorge

University of Lugano - Faculty of Economics; Swiss Finance Institute; European Corporate Governance Institute (ECGI)

Boaz Moselle

Ofgem

Richard J. Zeckhauser

Harvard University - Harvard Kennedy School (HKS); National Bureau of Economic Research (NBER)

Date Written: December 1996

Abstract

This paper analyses corporate risk choice when firms and their managers have private information regarding firm quality. Managers representing themselves or shareholders have a short time horizon and wish to boost the firm's reputation in the market. Investors observe the firm's current earnings to assess firm quality. Each firm has an opportunity locus for trading off risk and expected return. We show that even risk-neutral managers will choose risk strategically to influence market perceptions. Our model employs the following sequence: (1) a manager learns the firm's type (good or bad), which determines its opportunity locus relating to risk and expected return; (2) the manager selects a level of risk; (3) a period payoff is reaped; (4) potential purchasers of the firm draw inferences from the period payoff; and (5) the firm is sold in a competitive auction. If firms' choices of risk are observed by the market, pooling behavior results. Among the pooling equilibria, we show that good firms prefer those with lower variance, which reveal more information, whereas bad firms prefer higher variance equilibria. If risk level choices can only be partially observed, as we expect, and if the market has no strong prior belief about whether firms are good or bad, then good firms will hedge and bad firms will gamble. The latter seek to masquerade as good firms; good firms in turn seek to distinguish themselves. If the markets prior beliefs are highly unfavorable (favorable), both types gamble (hedge) hoping to alter (avoid refuting) these beliefs. Our empirical evidence confirms our theoretical results when risk choices are not fully observed. Firms with higher returns on assets have less variable performance.

JEL Classification: G3, D82

Suggested Citation

Degeorge, Francois and Moselle, Boaz and Zeckhauser, Richard J., Hedging and Gambling: Corporate Risk Choice When Informing the Market (December 1996). CEPR Discussion Paper Series Number 1520. Available at SSRN: https://ssrn.com/abstract=8295

Francois Degeorge (Contact Author)

University of Lugano - Faculty of Economics ( email )

via Giuseppe Buffi 13
CH-6904 Lugano
Switzerland
41 58 666 4634 (Phone)
41 58 666 4647 (Fax)

Swiss Finance Institute

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

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Boaz Moselle

Ofgem ( email )

9, Millbank
London SW1P 3GE
United Kingdom

Richard J. Zeckhauser

Harvard University - Harvard Kennedy School (HKS) ( email )

79 John F. Kennedy Street
Cambridge, MA 02138
United States
617-495-1174 (Phone)
617-384-9340 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States
617-495-1174 (Phone)
617-496-3783 (Fax)

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