Corporate Incentives for Hedging and Hedge Accounting

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact [email protected].. Oxford University Press and The Society for Financial Studies are collaborating with JSTOR to digitize, preserve and extend access to The Review of Financial Studies. This article explores the information effect offi-nancial risk management. Financial hedging improves the informativeness of corporate earnings as a signal of management ability and project quality by eliminating extraneous noise. Managerial and shareholder incentives regarding information transmission may differ, however , leading to conflicts regarding an optimal hedging policy. We show that these incentives depend on the accounting information made available by the flrmt Under some circumstances, if hedge transactions are not disclosed (i.e., firms report only aggregate earnings), managers hedge to achieve greater risk reduction than they would iffull disclosure were required. In these cases, it is optimalfor shareholders to request only aggregate accounting reports. Financial hedging, or "risk management," is an aspect of corporate financial policy that has received relatively little attention by economists. This is especially surprising given that the demand for such hedging by corporations is an important component of the explosion in financial innovation that has occurred in the last decade. Currency and interest rate derivative markets, for example, are dominated by corporate trading. Moreover, the current growth in the market for over-the-counter derivative securities, such as swaps, is largely due to a corporate demand to hedge specific risks. Given the prevalence and importance of this type of activity, the underlying economic rationale for, and implications of, corporate hedging are important questions to be considered. This article explores the use of financial hedging by managers motivated by career concerns. Our analysis demonstrates that the optimal hedging policy adopted by managers depends on the type of accounting information made available to shareholders. This connection sheds light on why managers often hedge accounting risk as opposed to, or in addition to, economic risk. Casual observation suggests that managers are concerned with the accounting consequences of their hedging decisions, and that in fact these consequences may influence their choice of hedging instrument, or whether they hedge at all. In addition, the connection between disclosure requirements and equilibrium hedging allows us to explore the consequences …