Agency Conflicts and Risk Management

This paper analyzes the relation between agency conflicts and risk management in a contingent claims model of the firm. In contrast to previous contributions, our analysis incorporates not only stockholder-debtholder conflicts but also managerstockholder conflicts. In particular we consider a setting in which the manager derives perquisitesfrom investment and overinvests when the firm has free cash flow. The paper shows that when investment policy is endogenous and depends on the selected financing and hedging policies, shareholders generally have no incentives to engage in asset substitution once debt has been issued. The paper also examines managers risk-shifting incentives and provides an analysis of the benefits associated with risk management in different economic enviromnents.