Do Firms Hedge Optimally? Evidence from an Exogenous Governance Change

Abstract

We find that an exogenously imposed board composition change significantly affected financial risk management. Using new proxies for the extent of financial risk management in non -financial firms we find that treated firms (those affected by the requirement to have a majority independent board) reduce their financial hedging in a difference-in -difference framework. The reduction is concentrated in firms with higher conflicts of interests factors, such as a high CEO equity ownership level, which exposes CEOs to more idiosyncratic risk, or a higher occurrence of option backdating. We reject the hypothesis that newly independent boards reduce financial hedging due to a lack of knowledge . First, we find no difference in financial hedging for firms where SOX mandated the addition of a financial expert relative to those that already had such expertise. Second , shareholder value increases more during the period of time of the listing rule deliberations for treated firms that hedge prior to the treatment. We conclude that some firms hedge excessively, reducing shareholder value— potentially to the benefit of under-diversified CEOs. Our findings also suggest that the board plays a significant monitoring role in financial risk management.