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Corporate Risk Management and the Incentive Effects of Debt
Author(s) -
CAMPBELL TIM S.,
KRACAW WILLIAM A.
Publication year - 1990
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1990.tb03736.x
Subject(s) - unobservable , incentive , agency cost , asset (computer security) , debt , business , hedge , agency (philosophy) , principal–agent problem , risk management , actuarial science , economics , microeconomics , monetary economics , finance , econometrics , corporate governance , ecology , philosophy , computer security , epistemology , biology , computer science , shareholder
This paper demonstrates how the incentive of manager‐equityholders to substitute toward riskier assets, commonly referred to as the “asset substitution problem,” is related to the level of observable risk in the firm. When observable and unobservable risks are sufficiently positively correlated, increases (decreases) in observable risk generate the incentive for manager‐equityholders to increase (decrease) unobservable risk. Thus, credible commitments to hedge observable risk can benefit the firm's manager‐equityholders by reducing the incentive to shift risk and the associated agency cost of debt. This provides a positive rationale for hedging diversifiable risk at the firm level.