ONLINE CHAPTER
Closely held companies are more likely to hedge risk exposures, because owners have a greater
proportion of their wealth invested in the company. Because the owners of these companies are less
diversified, they generally seek to minimise the risk exposures faced by the company. Similarly, if the
managers of the company are risk-averse, the company is more likely to pursue strategies that minimise
risk exposures. Research studies confirm these expectations. The hedging activities of companies increase
as share ownership by managers increases.
Another benefit of hedging is that it makes it easier for the board of directors and outsiders to evaluate the
performance of managers. Absent an effective risk-management program, it is difficult to disentangle company
performance due to the manager’s performance from company performance due to external factors. A manager
can make his or her performance more observable by minimising the company’s exposure to external risk
factors. For this reason, superior managers may be more inclined to hedge, whereas inferior managers may
prefer to disguise their performance behind the company’s unhedged performance.
Finally, even though shareholders can hedge the exposures they face as a result of owning shares in
a risky company, there are some circumstances under which it may be less costly for the company to
minimise risk than for the shareholders to hold a diversified portfolio. For some companies, however,
the costs of hedging outweigh the benefits. There are substantial fixed costs associated with hedging,
including the costs of acquiring the necessary expertise to implement a successful risk-management
program, and small companies are therefore less likely to hedge than large companies.
In their global survey of risk managers, Bodnar and colleagues^2 asked managers to rate the importance
of various motivations for their companies’ hedging programs. Figure 23.3 summarises some of their2 Bodnar, Graham, Harvey and Marston, ‘Managing Risk Management: Evidence from a Global Survey of Risk Managers’. Unpublished working
paper.TABLE 23.1 THE TAX INCENTIVE TO HEDGE
This table illustrates that when companies face higher tax rates as their earnings increase, the tax schedule creates an
incentive to hedge. If the company does not hedge, its expected after-tax earnings equal $8,667, but if it does hedge, it can
lock in after-tax earnings of $9,000.No hedging scenario
Input price High Medium Low
Taxable earnings $0 $10,000 $20,000- Taxes due 0 1,000 3,000
After-tax earnings $0 $9,000 $17,000
Expected after-tax earnings ()++()()=1
3
$0
1
3
$9, 000
1
3
$17, 000 $8, 667
Hedging scenario (input price locked in at medium)
Taxable earnings $10,000- Taxes due 1,000
After-tax earnings $ 9,000
Tax schedule
Tax rate on first $10,000 10%
Tax rate on earnings > $10,000 20%