The Optimal Hedge Ratio — An Analytical Decision Model Considering Periodical Accounting Constraints

In practice, it is observable that firms tend to smooth periodical earnings because periodical earnings are considered by capital markets as a proxy for firms' success, and therefore, are often operationalized by the respective compensation plans for managers. Considering financial hedging strategies such as purchasing financial derivatives, income smoothing can lead to a restricted use of financial derivatives even if it decreases firm value because the periodical changes of the value of financial derivatives possibly cause undesired volatilities in periodical earnings. In this paper, a deductive multi-period analytical decision model based on the capital market theory is presented to explain the influence of income smoothing on firms' hedging strategy. Thereby, principal-agent relations between a firm's investors and managers (decision makers) are assumed. Moreover, the decision model is applied to a real data set by conducting a sensitivity analysis. To our knowledge, this is the first paper to operationalize accounting constraints to determine how much a firm should hedge its risk exposure.