The Determinants of Firms' Hedging Policies Author(s): Clifford W. Smith and Rene M.

Stulz Source: The Journal of Financial and Quantitative Analysis, Vol. 20, No. 4 (Dec., 1985), pp. 391-405 Published by: University of Washington School of Business Administration Stable URL: http://www.jstor.org/stable/2330757 Accessed: 26/09/2010 13:03
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JOURNAL FINANCIAL QUANTITATIVE OF AND ANALYSIS

VOL.20,NO.4, DECEMBER 1985

The

Determinants

of Firms'

Hedging

Policies

Clifford W. Smith and

Rene

M. Stulz*

Abstract We develop a positive theoryof the hedging behavior of value-maximizingcorporations. We treathedgingby corporationssimplyas one partofthe firm'sfinancing decisions. We examine (1) taxes, (2) contracting costs, and (3) theimpactof hedgingpolicy on thefirm's investment decisions as explanations of the observed wide diversity hedgingpractices of among large, widely-heldcorporations.Our theoryprovides answers to the questions: (1) why some firms hedge and othersdo not; (2) why firms hedge some risksbut not others; and (3) why some firmshedge theiraccounting risk exposure while othershedge their economic value. I. Introduction

There is a considerable literature on the hedging practices of firms;1 how? ever, the focus is generally on risk-averse producers who use forward or futures markets to reduce the variability of their income.2 Although this literature pro? vides a useful basis for the analysis of hedging in closely-held corporations, partnerships, or individual proprietorships, it is not as applicable to large, widelyheld corporations whose owners, the stockholders and bondholders, have the ability to hold diversified portfolios of securities.3 In this paper, we develop a positive theory of hedging by value-maximizing corporations in which hedging is part of overall corporate financing policy. * Graduate School of Management, of NY Rochester, 14627,and Col? University Rochester, OH The Science,Ohio StateUniversity, Columbus, 43210, respectively. au? legeofAdministrative thors thank Meyers, Wakeman, P. L. and two anonymous for comments and JFQAreferees their Clifford Smithreceivessupport fromthe ManagerialEconomiesResearchCenter, suggestions. Graduate SchoolofManagement, of University Rochester. 1 A recent reviewof paperson hedging risksby Jacques[15] contains 80 foreign exchange references. 2 References consider hedging that the for agentsinclude[1], [2], [10], problems risk-averse [12], [13], [19], and[24]. 3 Noticethat literature thedemand insurance the on for addresses problem is similar the a that to discussed theliterature hedging. on for the of However, corporations, determinants the problem by demand insurance for differ from determinants hedging the of crucially policies.Fora corporation, thepurchase insurance of real due of in provides services to theexpertise insurance companies eval? sometypes risksand administering of claimssettlement of (for uating procedures an analysis these or see contracts no real services, [20]), whileforward futures provide apparent services. 391

Modigliani/Miller [21] show that, with fixed investment policy and with no contracting costs or taxes, corporate financing policy is irrelevant. Their argu? ment implies that if a firm chooses to change its hedging policy, investors who hold claims issued by the firmcan change their holdings of risky assets to offset any change in the firm's hedging policy, leaving the distribution of their future wealth unaffected.4 Thus, if the hedging policy affects the value of the firm, it must do so through (1) taxes, (2) contracting costs, or (3) the impact of hedging policy on the firm's investment decisions. We examine each of these potential explanations of the observed diversity of hedging practices among large widelyheld corporations.5 Our analysis provides answers to the following questions: (1) Why do some firms hedge while others do not? (2) Why do firms hedge some risks, but not others? (3) Why do some firms hedge accounting exposure, while others hedge economic values? A definition of hedging. A firmcan hedge by trading in a particular futures, forward, or option market even though it has no identifiable cash position in the underlying commodity. Furthermore, a firmcan hedge by altering real operating decisions; for instance, a merger can produce effects similar to those of hedging through financial contracts. Thus, we adopt a fairly general definition of hedging in terms of the market value of the firm. Let V(S) be the value of a firmif it does not hedge, where S is a vector of state variables. Consider two firms, a and b, that differ from the firm with value V(S) only in their hedging policies. We say that firma hedges more with respect to state variable /than firmb if the absolute value of the covariance of the value of firma with state variable / is less than or equal to that of firmb. Therefore, hedging reduces the dependence of firmvalue on changes in the state variable. Alternatively, we say that firm a hedges more than firmb if the absolute value of the covariance of the value of firma with the value of an unhedged firm with the same production policy and capital structure is less than or equal to that of firmb. II. Taxes and

Hedging

The structure of the tax code can make it advantageous for firms to take positions in futures, forward, or options markets. If effective marginal tax rates on corporations are an increasing function of the corporation's pre-tax value, then the after-tax value of the firm is a concave function of its pre-tax value. If hedging reduces the variability of pre-tax firm values, then the expected corpo? rate tax liability is reduced and the expected post-tax value of the firm is in? creased, as long as the cost ofthe hedge is not too large. See Figure 1.

4 If markets areperfect complete, valueofthefirm independent itshedging and the is of policy for other as if forward reasons, well. Forexample, a firm hedgesthevalueofan input purchasing by contracts that and and not input pricerises,thefirm's pricing production policiesshould be affected ofthehedge.Theopportunity oftheinput itscurrent cost is not bytheexistence price, the(sunk)cost ofthe forward contract. 5 This diversity been well documented thecase of has in risks.See, forin? foreign exchange stance, [23]. 392

CORPORATE TAX LIABILITY

E(T) E(T!H) POST-TAX FIRM VALUE

PRE-TAX FIRM VALUE

e(v-t:h) E(V-T)

Vk\. Vj[ E(V): E{T): E{T:H): E{V-T): E{V-T:H): C*:

PRE-TAX FIRM VALUE E(V)-(TE(V) Vk 'J without value ofthefirm hedging ifstatej [k]occurs. pre-tax without value offirm hedging. expected pre-tax without hedging. expected corporatetax liability with hedge. corporatetax liability a costless, perfect firm value without hedging. expected post-tax firm a value with costless, perfect hedge. post-tax maximum cost ofhedgingwhere hedging is profitable.

FIGURE 1 Corporate Tax Liabilityand Post-Tax FirmValue as a Function of Pre-Tax Firm Value value, then the firm's (Ifcostless hedging reduces the variabilityof pre-tax firm fails and its expected post-tax value rises.) expected tax liability

A.

Hedging and Corporate

Tax Liabilities

To analyze the effect of hedging on the present value of the firm's after-tax cash flow, we employ a state-preference model of firm value. We assume that there are s states of the world, with Vt defined as the pre-tax value of the firmin state ofthe world /. States ofthe world are numbered so that Vf ^ Vj, if / <j. Let 393

Pj be the price today of one dollar to be delivered in state of the world i, and TiVj) be the tax rate if the before-tax value of the firm is Vt. In the absence of leverage, the value ofthe firmafter taxes, V(0), is given by (i) v(o) = -

5>.(v. i= 1

r(v.)v.).

Hedging can increase the value of the firm if there are two states of the world, j and k, such that T(V) < T(Vk). To demonstrate this, suppose that the firmholds a hedge portfolio such that VJ + Hj = Vk + Hk, and that the hedge portfolio is self-financing in the sense that PjHj + PkHk = 0. (Such a portfolio is feasible if it is possible to create a portfolio that pays one dollar in state j and a portfolio that pays one dollar in state k.) Let V^O) be the value ofthe hedged firm. It follows that v"(0) v(o) = F.(r(K)v. + t(v. ~ + h)(v. + + //.)) + Hk)) > 0 .

Pk{T{Vk)Vk

T(Vk

Hk)(Vk

(The inequality is implied by the definition of a concave function.) Therefore, costless hedging increases the value of the firm. This analysis also implies that incomplete hedging (i.e., hedging that does not eliminate all uncertainty in future cash flows) also raises firmvalue. The previous analysis must be modified if hedging is costly. If transactions costs of hedging do not exceed the benefits identified in (2), i.e., V^(0) ?V(0), hedging increases firm value. The amount of hedging undertaken by the firm depends on the transactions cost structure of hedging. If transactions costs ex? hibit scale economies, then the firm either hedges completely, if the cost is low enough, or hedges nothing. Hedging can be costly because the firm purchases before-tax cash flows from investors who receive after-tax cash flows. If the marginal investor's tax function is linear in the payoffs of the hedging instruments, our analysis still holds; the self-financing hedge portfolio analysis is still valid. However, if inves? tors' tax functions are nonlinear and investors face different tax rates across states, the analysis is more complex. It could be the case that the decrease in the firm's expected tax liability from hedging is offset by an increase in the expected tax liability ofthe investors who enable the firmto hedge. Thus, there may be no impact on expected taxes. Hedging instruments would be priced accordingly and there would be no benefit from hedging. However, in this case, it would pay firmsthat expect to face a constant tax rate to offer hedging instruments to firms that expect their tax rate to be an increasing function of their cash flow. This mechanism tends to produce hedging instrument prices as if the marginal inves? tor faces a linear tax function.6

6 Cornell offers somesupporting for conjecture. evidence this [6] 394

B.

Empirical Implications

The basic provisions of the corporate tax code (a zero tax rate on negative taxable income, moderate progressivity for taxable income under $100,000 and a constant rate thereafter) yield a convex statutorytax function. The convex region is extended by tax preference items like the investment tax credit that offset a stated maximum fraction, x, of a corporation's tax liability.7 The effective mar? ginal tax rate is constant only if taxable income exceeds Ux times the corpora? tion's accumulated investment tax credits, a number that can substantially exceed $100,000. DeAngelo and Masulis [7] report that over the period 1964-1973, in any year an average of 27 percent of the firms flling tax returns paid no taxes; for the largest corporations, the average was between 10 percent and 20 percent. The tax-reducing benefits of hedging increase if the function that yields after-tax income becomes more concave. Thus, if excess-proflts taxes or invest? ment-tax credits increase the convexity of the tax function, then such a tax will induce firms to hedge more. Conversely, allowing trading in tax credits reduces the convexity ofthe tax function and reduces the tax benefits of hedging.8 The three-year carry-back, fifteen-yearcarry-forwardprovision and the pro? gressivity provisions of the tax code produce local concavities in the tax func? tion.9 A firm that faces concavities in the tax function finds it profitable to "re? verse hedge," increasing the variability of its taxable income over that range of outcomes. III. A. Debt and Policies

Hedging

Transactions

Costs of Bankruptcy

Transactions costs of bankruptcy can induce widely-held corporations to hedge.10 Consider a levered firmthat pays taxes on its cash flows net of interest payments to the bondholders. Let F be the face value of debt. If the value of the firm is below F at maturity, the bondholders receive F minus the transactions costs of bankruptcy. Otherwise, the shareholders receive firmvalue minus both taxes paid and the bondholders' payment, F. The lower are expected bankruptcy 7 Fortaxyears1983 and 1984, themaximum offset theinvestment credit 85 per? is tax tax by in it 90 in cent.It was 50 percent 1978, and increased 10 percent yearuntil reached percent by per 1982. 8 Regulations equivalent in-kind taxes. For example,if unexpectedly are to largechangesin these additional then to constraints thefirm, on firm valuelead politicians imposeadditional regula? if from filing a taxform. of Notealso that the do costsareliketaxeseventhough they notresult tory in of then on numbers, this regulations imposecontraints firms expressed terms accounting typically values. rather economic than for to establishes incentives firms hedgeaccounting 9 The fifteen-year forward the losses.Notice that exis? operating carry provision appliesonlyfor to the tax further tence a minimum introduces tax of However, minimum tends make complications. as that sometaxeswill of after-tax income moreof a concavefunction before-tax income, itimplies on evidence theuse of theseprovi? be paid on positive cash flows.Cordesand Sheffrin present [5] sions. 10Diamond[8] also arguesthatbankruptcy In costs lead to hedging. his modelof financial haveno incen? financial intermediaries i.e., all risksthat risks, intermediaries, hedgeall systematic it are tiveeffects. inclusions stronger oursbecausein hismodelthere no cases in which are than His discussed this in costs other reasons either doesnotpaytohedge, becauseoftransaction orfor paper. 395

costs, the higher the expected payoffs to the firm's claimholders. By reducing the variability ofthe futurevalue ofthe firm,hedging lowers the probability of incurring bankruptcy costs. This decrease in expected bankruptcy costs benefits share? holders. Figure 2 illustrates this point. If transactions costs of bankruptcy are a decreasing function of firmvalue, and the tax rate is either constant or an increas? ing function of firm value, expected after-tax firmvalue net of bankruptcy costs is higher if the firmcan costlessly hedge. To extend our analysis, we consider a simple model in which a firmissues debt to create a tax shield. Again, let Pt be the price today of one dollar delivered in state / and T(Vt) be the tax rate, if the before-tax value of the firmis V{. In the absence of leverage, the after-tax value of the firm is V(0). We assume a lever? aged firm issues pure discount bonds with face value F, and pays taxes on its before-tax value net of its payment to the bondholders. The after-tax value of a levered firmwith the same investment policy as the unlevered firmis V(F). For simplicity, it is assumed that Vj < F < Vk. If Vt < F, bankruptcy costs are given by C(Vj) ^ Vh The difference in the value of the levered firmand the unlevered firmis given by (3) V(F) V(0) = fpt{T(v)vt 1=1 C(V.)) + i>7tv.)F, i=k

where F corresponds to the payment to the bondholders in the absence of bank? ruptcy. By inspection, the value ofthe levered firmequals the value ofthe unlev? ered firm minus the present value of bankruptcy costs plus the present value of the tax shield from interest payments.11 From equation (3), the value of the lev? ered firm increases with decreases in the present value of expected bankruptcy costs.12 To analyze the effects of hedging on expected bankruptcy costs, we exam? ine an unlevered firm whose shareholders plan to issue debt. Since potential bondholders have no market power, shareholders capture any increase in firm value from bond issuance. We assume that investment policy is fixed, (V/(0) is given for all is), and that any proceeds of a debt issue are distributed to the share? holders as a dividend. The firmcan reduce bankruptcy costs by holding a hedge portfolio that pays positive amounts when the firmwould be bankrupt without hedging. To analyze the benefits of hedging, consider a hedge that pays < 0 in state g and Hm>0 Hg in state m. We assume the hedge portfolio involves no current cash flows (i.e., = 0) and that and Vm + Hm > F. By construction, PgHg + PmHm Vg + Hg>F < F. Let VH{F) be the value of the leveraged firm if the firmhedges. Then, Vg assuming a constant tax rate T, we have = . + (4) V"(F) V(F) PgC(Vg) Pj(F-V) 1' The modelwe is to employ similar those [17] developed KrausandLitzenberger andBren? by nanandSchwartz Whileourtreatment taxesis notvery of it to [4]. sophisticated,is important understand that roleplayedby taxesin thisanalysis simply justify existence debt.A more the is to the of realistic treatmenttaxeswouldnotadd important of to insights ouranalysis. 12Notethat witha moresophisticated treatment taxestheanalysis of becomesmorecomplex. As theprobability bankruptcy of the and decreases, promised yieldof thedebtdecreases so does its taxshield. 396

BANKRUPTCY COSTS

E(B) NET POST-TAX FIRM VALUE

PRE-TAX FIRM VALUE

e(vn:h) E(VN)

PRE-TAX FIRM VALUE E(V)-C without value ofthefirm hedging ifstatej[k] occurs. \/y[\4]: pre-tax face value ofthe debt. F: without value ofthefirm hedging. expected pre-tax E(V): without netexpected post-taxvalue ofthefirm hedging. E{ VN): with perfect, a costless hedge. value ofthefirm E(VN:H): netexpected post-tax cost without hedging. expected bankruptcy E(B): cost with perfect hedgingwillbe zero inthiscase. E{B:H): expected bankruptcy cost ofhedgingwherehedging is profitable. maximum C*: FIGURE 2 Post-Tax FirmValue as a Function of Pre-Tax FirmValue in the Presence of Bankruptcy Costs value, then the firm's (Ifcostless hedging reduces the variabilityof pre-tax firm expected bankruptcycosts falland its net (of bankruptcycosts) expected post-tax value of the firm increases.) Since C(Vg) > 0 and Vg < F, VH(F) - V(F) is always positive. Thus, the hedge decreases the present value of bankruptcy costs and increases the present value of the tax shield of debt. (With a constant tax rate, expected tax payments from the hedge are zero unless the firmis bankrupt when the hedge pays off.) Sharehold397

ers benefit from hedging only because bankruptcy involves real costs to stock? direct bankruptcy costs and the loss of debt tax holders and bondholders?the shields. Again, with costly hedging it is still generally profitable to hedge. However, shareholders must account for hedging costs when they decide among alternative hedging strategies. B. Bond Covenants and Costs of Financial Distress

For hedging to increase shareholder wealth, the firm must convince poten? tial bondholders that it will hedge after the bond sale and, hence, that expected bankruptcy costs are not as high as the firm's investment policy would otherwise suggest. But potential bondholders recognize that hedging after the sale of the debt is not in the stockholders' best interests. Although hedging increases the value ofthe firm,it also redistributes wealth from shareholders to bondholders in a way that makes shareholders worse off.13 Without an incentive to hedge, de? spite promising to do so, it will be difficult for the firmto make a credible an? nouncement that it will hedge.14 There are at least two ways that market forces create incentives for share? holders to pursue a hedging policy. First, if the firmborrows frequently, it bene? fits from a reputation for hedging since that reputation increases the price for its new debt. Yet, such a reputation is not likely to be sufficient to insure that the firmwill hedge when the probability of bankruptcy is large. Then, the gain from no longer hedging is likely to outweigh the cost of lost reputation, since the repu? tation is valuable only if the firmsuccessfully avoids bankruptcy. Second, hedg? ing provides a means whereby the firmcan reduce the costs of financial distress imposed by bond covenants that constrain the shareholders to take actions they would otherwise avoid. For instance, binding bond covenants can force the firm to alter its investment policy; hedging can reduce the likelihood that covenants become binding. C. Empirical Implications

Warner [28] suggests that transactions costs of bankruptcy are a small frac? tion of large firms' assets. Yet, small bankruptcy costs can be sufficientto induce large firms to hedge, if the reduction in expected bankruptcy costs exceeds the costs of hedging. Warner also indicates that the bankruptcy costs are less than proportional to firm size. If hedging costs are proportional, the reduction in ex? pected bankruptcy costs is greater for the small corporation, and, hence, small firmsare more likely to hedge. A firmcan hedge to reduce the expected costs of financial distress. Because bond covenants use accounting numbers to define states where the firm's activi13In thiscontext, decisionnotto hedgeafter on the debthas beensold has thesameeffect the assetfora less risky asset. shareholders' wealth a decisionby thefirm substitutemorerisky a as to See [25]. 14Notethat is an example a time-inconsistent this of optimal policy.See [18]. 398

ties are restricted,15a firmthat wants to decrease the probability of financial dis? tress must manage its accounting numbers so that bond covenants do not become binding. It is thus possible for a value-maximizing firmto choose to reduce the variance of its accounting earnings, even if this increases the variance of eco? nomic earnings.16 IV. Managerial Compensation, Risk Aversion, and Hedging

The corporation's managers, employees, suppliers, and customers are fre? quently unable to diversify risks specific to their claims on the corporation. Be? cause they are risk averse, these individuals require extra compensation to bear the nondiversifiable risk ofthe claims.17 With limited liability, the amount of risk that can be allocated to the stockholders is restricted by the company's capital stock. But the firm can reduce the risk imposed on other claimholders by hedg? ing. Thus, as long as the reduction in compensation of managers and employees and other suppliers plus the increased revenues from customers exceed the costs of hedging, hedging increases the value ofthe firm. A. Managerial Risk Aversion and Hedging

Shareholders hire managers because they have specialized resources that in? crease the value ofthe firm. Managers cannot use their expertise unless they have some discretion in the choice of their actions. Yet, unless faced with proper in? centives, managers will not maximize shareholder wealth. The managerial com? pensation contract must be designed so that when managers increase the value of the firm,they also increase their expected utility. Frequently observed provisions of managerial compensation contracts make the manager's total current compen? sation an increasing function of firmvalue.18 The managers' expected utility depends on the distribution of the firm's payoffs. Hedging changes the distribution of the firm's payoffs and, therefore, changes the managers' expected utility. To analyze the managers' hedging choices, we define hedging as the acquisition of financial assets that reduce the variance of the firm's payoffs. The firm is assumed to acquire a hedge portfolio 15See [25] for description analysis bondcovenants. a and of 16One also wouldexpectfirms hedgemoreif accounting rulesare changed increase the to to variance accounting under of will FASB 52 than FASB 8, as Thus,firms hedgeless under earnings. translation FASB 52 while in whenthey occurunder gainsand losses are notrecognized earnings wereunder FASB 8. they 17Employees is demandhigher of demand wages if theprobability layoff greater. Managers salaries(or perhaps if even an equitystakein thecompany) therisks failure, of insolvency, higher and financial are set terms long-term in contracts embarrassment great.Suppliers moreunfavorable with whoseprospects moreuncertain. customers, are And concerned abouta company's companies to their in will or to ability service warranty products thefuture fulfill obligations, be reluctant buyits an when of of products. Reaganand Stulz [22] provide analysis risk-sharing one party thecontract hasa comparative in risks to advantage using capitalmarkets diversify away. 18See [26] fora description analysis theprovisions management con? and of of compensation tracts see [11] fora discussion thespeeification bonusplans.Notealso that assumethe and of we of a tax wealth more tax manager's marginal rateis constant. Progressive ratesonlymakemanagerial concavefunction firm of valueandthus reinforce results our basedon risk aversion alone. 399

that creates neither a cash inflow nor outflow at acquisition. Let Ht be the payoff ofthe hedge portfolio in state ofthe world i so that (5) h. = YNrQr j

where Nj is the number of shares of asset j purchased, and Q(j is the payoff of one share of asset j in state of the world i. To derive the optional hedge portfolio, we assume a two-period world in which the manager's end-of-period wealth equals the sum of his pecuniary com? pensation plus the payoff of his nontradeable investment in the firm. This implies that the manager's indirect utility function in state /is a function only of his endof-period wealth in state /, written W(; and his wealth is an increasing function of the total value ofthe firmin state /, i.e., V, +//,, (6) U. = U(W(V. + //.)); i = 1, . . .,S.

The indirect utility function of wealth is assumed to be strictlyconcave; thus, the manager is risk averse. With these assumptions, the manager maximizes ex? pected utility (7) U = ]>> i ? U(W(Vi + Hi)) ?

where p( is the probability of state / occurring, subject to the budget condition that (8) *jNj ? Q0J = 0 .

where Q0j is the price at the beginning of the period of a share of asset j. To obtain the optimal number of shares of each security, Nj9 the first-ordercondi? tions are

^0/

^0k

conditions state where W' is the firstderivative of function W('). The first-order that the marginal increase in expected utility per dollar of security j purchased must equal the marginal increase in expected utility per dollar of security k pur? chased. To simplify, we assume that all financial assets have equal expected rates of return and that the firmincurs no transactions costs when it purchases or sells financial assets. The solution to the hedging problem has several interesting properties. First, if the manager's end-of-period wealth is a concave function of the end-ofperiod firmvalue, the optimal hedging strategy is to hedge the firmcompletely, if this is feasible. The expected income of the manager is maximized if the firmis completely hedged, because the expected value of a concave function of a ran400

dom variable is smaller than the value of the function evaluated at the expected value of the random variable (Jensen's Inequality). As the manager is risk averse, he will choose to bear risk only if he is rewarded for doing so by higher expected income. Since his expected income is maximized when the firmis com? pletely hedged, the manager will choose to bear no risk.19 Second, if the manager's end-of-period wealth is a convex functon of the end-of-period firm value, but the manager's expected utility is still a concave function of the end-of-period value of the firm, the optimal strategy generally will be to eliminate some, but not all, uncertainty through hedging. In this case, the expected income of the manager is higher if the firmdoes not hedge, since his income is a convex function ofthe value ofthe firm. However, because the man? ager is risk averse, he will want to give up some expected income to reduce risk. Faced with a trade off between expected income and risk of income, the manager will not, in general, choose a policy that makes his income riskless. Third, if the manager's end-of-period utility is a convex function ofthe endof-period firm value, Jensen's Inequality implies that the manager's end-of-pe? riod utility has a higher expected value if the firmis not hedged at all. Bonus or stock option provisions of compensation plans can make the manager's expected utility a convex function of the value of the firm. If the manager's expected util? ity is a convex function of the value of the firm, the manager will behave like a risk-seeker even though his expected utility function is a concave function of his end-of-period wealth. An example of a situation in which a firmdoes not hedge even though the manager is risk averse can make this point clearer. We assume that the compen? sation contract promises a payment equal to T+Max^-A^O). The option-like feature of this contract can be found in many compensation contracts. For simplicity, we assume that 5 = 2 and V2 > K > Vx > 4T. The manager is assumed to maximize an expected utility function ofthe form (10) U = P^wf + P2-jM2\ d < 1 .

The firmhedges if it purchases financial assets that pay a positive amount in state 1 and a negative amount in state 2. Given our assumptions, the expected payoff ofthe hedge portfolio must equal zero, which implies that//2 = (-px/p2)Hx. By eliminating H2 in equation (7) and taking the partial derivative ofthe manager's expected utility with respect to Hx, one can easily verify that U is a decreasing function of Hx for positive values of Hx equal to or smaller than the value of Hx required to hedge the value of the firm completely. Thus, the structure of the manager's compensation package can induce him not to hedge the firmat all. Frequently, compensation packages make the manager's end-of-period wealth a concave function of the firmvalue in some regions and a convex func? tion in others. This suggests that hedging will take place for some values of the firmand not others. Furthermore, for values ofthe firmthat make the manager's end-of-period wealth a convex function of firm value, the manager may choose 19Thisresult equivalent Arrow's[3] is to that individual offered fairly proposition a risk-averse insurance insures. also [14]. See priced fully 401

to "reverse-hedge" (make the value of the firm even more dependent on the realization of some state variable). We have assumed that the expected rates of returnon all financial assets are equal and that transactions costs are negligible.20 If expected returns to financial assets vary, the manager faces a trade off between expected income and risk of income. In such cases, he will hedge less if hedging involves going short in a portfolio with a high expected return. If transactions costs increase, the firmwill hedge less, as hedging decreases the manager's expected end-of-period wealth. We also must assume that the firmhas a comparative advantage in hedging over the manager. In other words, it should not pay for the manager to hedge his endof-period wealth on his personal account. The combination of transactions costs, economies of scale, and the large number of managers within any firmmake this comparative advantage likely.21 B. Managerial Compensation and Hedging

Our analysis has, thus far, taken as given the form ofthe management com? pensation contract. This analysis is interesting in itself since it produces positive statements about the firm's hedging policies. In reality, however, shareholders choose the management compensation package and, thereby, affect the hedging managers undertake. Making managerial wealth a concave function of firmvalue bonds the firmto a hedging policy. This should be important for a firmwith debt or other fixed claims, as it offers greater assurance that the firm will hedge as long as that compensation policy is followed. Managers whose compensation is a concave (or not too convex) function of firmvalue have incentives to reduce firmcash flow variability. Hence, such man? agers might reject variance-increasing positive net present value (NPV) projects. If hedging costs are negligible, it pays to let managers hedge as this increases incentives to take variance-increasing positive NPV projects. If shareholders in? stead tryto prohibit hedging, managers will focus more on nonpriced risks. Still, as long as their compensation depends on firm value, managers have incentives to consider market valuation in evaluating projects. With costly hedging, shareholders have incentives to devise a compensation plan that discourages managers from devoting excessive resources to hedging. This can be accomplished when computing the manager's compensation by fil? tering out those changes in firm value that are not under the manager's control and by making the manager's compensation a more convex function of firm value. However, it will generally not be efficient to eliminate all incentives to hedge. Earlier sections have demonstrated that hedging can be profitable. Moreover, a compensation plan that eliminates all hedging incentives would be costly to negotiate and implement.22 20Stulz [27] derives in framework whenholding strategies a continuous-time hedging optimal of differ acrossassetsfor the rates return and costsforforward contracts positive whenexpected are case offoreign exchange exposure. 21If there a singlemanager, to can is scale economies stillinducethemanager hedgethrough usefulto hedgea is contracts too largeto makethem thefirm. Note thatthesize of mostfutures income. manager's 22The Diamond/Verrecchia analysis out that wouldfilter theeffect [9] suggests bonusschemes 402

C.

Empirical Implications

A manager's compensation often includes a payment whose value depends on accounting earnings. It follows that the manager's expected utility depends on both the firm's market value and its accounting earnings. If the manager's ex? pected utility depends heavily on accounting earnings and is a concave function of accounting earnings, one would expect the firmto principally hedge account? ing earnings even if doing so increases the variance ofthe firm's economic value. Managers' risk aversion can lead them to hedge, but it does not necessarily do so. If the compensation package of the manager is such that his income is a convex function of the value of the firm, it can be the case that the manager is better off if the firm does not hedge. Hence, the more option-like features in a firm's compensation plan, the less the firm is expected to hedge. For instance, bonus plans that make a payment to managers only if accounting earnings exceed some target number will induce managers to hedge less since this payment is a convex function of accounting earnings. If the manager owns a significant fraction of the firm, one would expect the firmto hedge more, as the manager's end-of-period wealth is more a linear func? tion of the value of the firm. This reinforces the incentive for closely-held firms to hedge since the owners are unlikely to hold well-diversified portfolios and, thus, have incentives to induce managers to reduce the variance of the firm's returns. V. Summary and Conclusions

This paper presents an analysis of the hedging behavior of firmsthat differs fundamentally from the existing literature. Rather than assuming that the firmis risk averse, we follow modern finance theory and assume that incentives exist within the contracting process to maximize the market value ofthe firm. We then show that a value-maximizing firm can hedge for three reasons: (1) taxes, (2) costs of financial distress, and (3) managerial risk aversion. Our analysis offers a framework within which the wide diversity of hedging practices among firmscan be understood. Further research should focus on empirical tests of the implications of our analysis. To implement the tests, however, more detailed data are required than are available from sources such as Compustat, in which firms' hedging activities are aggregated with other contingent outcomes such as insurance contracts and outstanding lawsuits. Transactions, such as mergers, also accomplish some of the same results as hedging, although it is likely to be difficult to appropriately control for other changes in investment and financing policy to focus on these hedging characteristics.

in has the such ofvariables overwhich However, difficulty administering a management no control. must are observed. scheme why they rarely explain 403

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