Hedging and Gambling: Corporate Risk Choice when Informing the Market

This paper analyses corporate risk choice when firms and their managers have private information regarding firm quality. Managers – representing themselves or shareholders – have a short time horizon and wish to boost the firm’s reputation in the market. Investors observe the firm’s current earnings to assess firm quality. Each firm has an opportunity locus for trading off risk and expected return. We show that even risk-neutral managers will choose risk strategically to influence market perceptions. Our model employs the following sequence: (1) a manager learns the firm’s type (good or bad), which determines its opportunity locus relating to risk and expected return; (2) the manager selects a level of risk; (3) a period payoff is reaped; (4) potential purchasers of the firm draw inferences from the period payoff; and (5) the firm is sold in a competitive auction. If firms’ choices of risk are observed by the market, pooling behaviour results. Among the pooling equilibria, we show that good firms prefer those with lower variance, which reveal more information, whereas bad firms prefer higher variance equilibria. If risk level choices can only be partially observed, as we expect, and if the market has no strong prior belief about whether firms are good or bad, then good firms will hedge and bad firms will gamble. The latter seek to masquerade as good firms; good firms in turn seek to distinguish themselves. If the market’s prior beliefs are highly unfavourable (favourable), both types gamble (hedge) hoping to alter (avoid refuting) these beliefs. Our empirical evidence confirms our theoretical results when risk choices are not fully observed. Firms with higher returns on assets have less variable performance.