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Hedging and Gambling: Corporate Risk Choice When Informing the Market

Author

Listed:
  • François Degeorge

    (HEC Paris - Recherche - Hors Laboratoire - HEC Paris - Ecole des Hautes Etudes Commerciales)

  • B. Moselle
  • R.J. Zeckhauser

Abstract

This paper analyses corporate risk choice when firms and their managers have private information regarding firm quality. Managers representing themselves or shareholders have a short time horizon and wish to boost the firm's reputation in the market. Investors observe the firm's current earnings to assess firm quality. Each firm has an opportunity locus for trading off risk and expected return. We show that even risk-neutral managers will choose risk strategically to influence market perceptions. Our model employs the following sequence: (1) a manager learns the firm's type (good or bad), which determines its opportunity locus relating to risk and expected return; (2) the manager selects a level of risk; (3) a period payoff is reaped; (4) potential purchasers of the firm draw inferences from the period payoff; and (5) the firm is sold in a competitive auction. If firms' choices of risk are observed by the market, pooling behavior results. Among the pooling equilibria, we show that good firms prefer those with lower variance, which reveal more information, whereas bad firms prefer higher variance equilibria. If risk level choices can only be partially observed, as we expect, and if the market has no strong prior belief about whether firms are good or bad, then good firms will hedge and bad firms will gamble. The latter seek to masquerade as good firms; good firms in turn seek to distinguish themselves. If the markets prior beliefs are highly unfavorable (favorable), both types gamble (hedge) hoping to alter (avoid refuting) these beliefs. Our empirical evidence confirms our theoretical results when risk choices are not fully observed. Firms with higher returns on assets have less variable performance.

Suggested Citation

  • François Degeorge & B. Moselle & R.J. Zeckhauser, 1996. "Hedging and Gambling: Corporate Risk Choice When Informing the Market," Working Papers hal-00606074, HAL.
    • Handle: RePEc:hal:wpaper:hal-00606074
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    Cited by:

    1. Erasmo Giambona & John R. Graham & Campbell R. Harvey & Gordon M. Bodnar, 2018. "The Theory and Practice of Corporate Risk Management: Evidence from the Field," Financial Management, Financial Management Association International, vol. 47(4), pages 783-832, December.
    2. Dan Bernhardt & Ed Nosal, 2013. "Gambling for Dollars: Strategic Hedge Fund Manager Investment," Working Paper Series WP-2013-23, Federal Reserve Bank of Chicago.
    3. Monda, Barbara & Giorgino, Marco & Modolin, Ileana, 2013. "Rationales for Corporate Risk Management - A Critical Literature Review," MPRA Paper 45420, University Library of Munich, Germany.
    4. Downie, David & Nosal, Ed, 2003. "A strategic approach to hedging and contracting," International Journal of Industrial Organization, Elsevier, vol. 21(3), pages 399-417, March.
    5. Ammon, Norbert, 1998. "Why Hedge? - A Critical Review of Theory and Empirical Evidence -," ZEW Discussion Papers 98-18, ZEW - Leibniz Centre for European Economic Research.
    6. Bingxuan Lin & Chen-Miao Lin, 2012. "Asymmetric Information and Corporate Risk Management by Using Foreign Currency Derivatives," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 15(01), pages 1-19.

    More about this item

    Keywords

    Risk Choice; Agency Costs; Hedging; Private Information;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G3 - Financial Economics - - Corporate Finance and Governance

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