Why Do Firms Hedge? An Asymmetric Information Approach

Abstract

We present an asymmetric information model of hedging that has the intuition that hedging is undertaken by higher ability managers who wish to lock-in the higher profits that result from their higher ability. Thus, hedging is an attempt to improve the informativeness of the learning process by the higher ability manager. We analyze two models. We first analyze a model where managers care only about their reputations. In this case, we show that an intuitive equilibrium that involves hedging by higher ability managers always exists. Lower ability managers also hedge when differences in abilities are low but do not hedge when differences in abilities are high. We consider a second model where managers hold equity in the firm in addition to caring for their managerial reputations. The presence of FDIC insurance or pre-existing debt makes hedging costly to equity holders as it is a variance reducing activity. However this cost of hedging is lower for higher ability managers. This leads to both kinds of managers not hedging when the difference in ability is low. At higher differences in ability, the intuitive equilibrium in which the higher ability manager hedges exists. In this equilibrium, greater separation occurs relative to the case where managers were only concerned about their reputations.