Why Do Firms Hedge? An Asymmetric Information Model

Abstract

We present an asymmetric information model of hedging that has the insight that hedging is undertaken by managers with higher ability who wish to lock-in the greater profits that result from that ability, thereby allowing the market to learn this higher ability more quickly. Thus, hedging is an attempt to improve the informativeness of the learning process by the higher ability manager. We analyze two models: First, a model in which managers care only about their reputations. In this case, we show that an intuitive equilibrium involving 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 then consider a second model in which 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, the cost of hedging is lower for higher ability managers. This leads to both types of managers not hedging when 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 in which managers were only concerned about their reputations.

TOPICS: Derivatives applications, options