Corporate Incentives for Hedging and Hedge Accounting

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The aim of this term paper is to supply an analysis on the rationales for corporations to apply hedging and hedge accounting. In order to do so, P. M. DeMarzo and D. Duffie’s paper “Corporate Incentives for Hedging and Hedge Accounting” published 1995 will be reviewed and analysed. This term paper will start with a short review of the literature on corporate risk management and hedging policies and then move on to a description of the model developed by DeMarzo and Duffie and its rationale. Then, their findings and propositions will be presented followed by the conclusion. Literature Review

“Corporate Incentives for Hedging and Hedge accounting” by P. M. DeMarzo and D. Duffie is a paper published 1995 in The Review of Financial Studies. It investigates, as the titel already suggests, the reasons of why management of corporations decides to employ hedging and hedge accounting, while considering accounting standards as a key factor. It illustrates why managers decide to hedge accounting risks rather than economic risks and how this is linked to managers’ wages. For this reason the authors build a model in their paper in order to show the interaction between hedging, the investors and the impact on future wages of management, denoting it as the informational effect of hedging.

Until the publication of DeMarzo and Duffie’s paper, there already has been some literature on incentives to why corporations apply risk management, particularly through hedging. Modigliani and Miller’s proposition (1958) shows that in perfect market conditions financial risk management would prove irrelevant since shareholders would have the ability to apply the same tools as corporations to manage their risk. Financial risk management therefore is beneficial since there are market imperfections and from hedging, a firm can derive value. Even though before DeMarzo and Duffie the topic of risk management had been relatively young, up to today a considerable amount of literature about hedging has been released. Smith and Stulz (1985) published one of the first papers on hedging; others include Froot et al (1993), Geczy et al (1997), Tufano (1998) and Chowdry and Howe (1999) that have investigated the rationales and conditions to why corporations hedge. Imperfections such as taxes, bankruptcy costs, transaction costs, asymmetric information, agency costs as well as market conditions that multinational firms face in an increasingly global business world, make hedging beneficial, just to name a few.

There are different types of hedging which include, among others, natural hedges (buying two neg. correlated financial instruments) or operational hedges (a broad term that might include a firm acquiring another, building plants in different countries etc) et al. Here, the main focus is on derivative hedging, meaning the firm using instruments such as forwards, futures, swaps and option to manage their risk exposure. While Smith and Stulz (1985) and investigate the reasons for hedging on a general basis, Froot et al (1993) go a step further by developing a framework for corporate risk management. They also differentiate between the instruments, illustrating under which (specific and simplified) conditions a firm might rather use futures than forwards depending on its foreign income and exchange risk exposure (Froot et al, 1993). Their paper represents the growth of interest in risk management and financial hedging policies. Today, risk management is an important operational part of business with practices growing popular.

Theoretically, since literature is suggesting that hedging, due to market imperfections, is indeed a value-enhancing activity, then investors should incorporate that information into prices. On this specific matter, however, opinions are not in complete agreement. Authors including Allayanis and Weston (2001), Carter et al (2006), Adam and Fernando (2006) present favorable evidence on the hypothesis that firm value is...
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