Managerial hedging and equity ownership

Finance

IFA Working Paper

2002

Risk-averse managers can hedge the aggregate component of their exposure to firm's cash flow risk by trading in financial markets, but cannot hedge their firm-specific exposure. This gives them incentives to pass up firm-specific projects in favor of standard projects that contain greater aggregate risk. Such risk substitution gives rise to excessive aggregate risk in stock markets and excessive correlation of returns across firms and sectors, thereby reducing the risk-sharing among stock market investors. Managerial ownership of the firm can be designed to mitigate theis externality. We characterize the resulting endogenous relationship between the managerial ownership and the extent of aggregate risk in the firm's cash flows, and discuss its implications for existing empirical research.

This Working Paper has been updated. Please see IFA 446.

Institute of Finance and Accounting

FIN 361

IFA Working Paper

No