Corporate Incentives for Hedging and Hedge Accounting
Abstract
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
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
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