Agency Conflicts and Risk Management

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.