Hedging Policies, Incentives and Market Power

Posted by D. Daniel Sokol

David De Angelis, Cornell University - Samuel Curtis Johnson Graduate School of Management and S. Abraham Ravid, University of Chicago - Booth School of Business, Rutgers University - Department of Finance & Economics discuss Hedging Policies, Incentives and Market Power.

ABSTRACT: This paper studies potential adverse incentive effects of hedging policies in non-competitive product markets. We develop an illustrative model which shows that for firms with market power, output hedging creates detrimental incentives, which are not present in competitive markets. This adds to the cost of hedging. Thus we expect firms with market power in non-competitive environments to be less inclined to hedge outputs. We test this prediction on a sample of S&P500 firms from 2001 to 2005. Consistent with our model, we find that firms with market power tend not to hedge output commodity risk, while they tend to hedge input commodity risk. These results are robust to various econometric specifications and also robust when considering currency hedging. We also find support for some "traditional" variables which predict the tendency to hedge.