Corporate Risk Management and the Incentive Effects of Debt

TIM S. CAMPBELL, WILLIAM A. KRACAW

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Abstract

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. 1990 The American Finance Association

Original languageEnglish (US)
Pages (from-to)1673-1686
Number of pages14
JournalThe Journal of Finance
Volume45
Issue number5
DOIs
Publication statusPublished - Dec 1990

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All Science Journal Classification (ASJC) codes

  • Accounting
  • Finance
  • Economics and Econometrics

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