Suppose the cash flows from financial hedging are pooled with the cash flows from a firm's operations and that the shareholders cannot ascertain the ultimate sources of profits and losses
Would the managers of the firm want to hedge or to speculate in the forward foreign exchange market?
The Peter DeMarzo and Darrell Duffie (1995) argument is the following. Shareholders must gauge the quality of the firm's managers based on their observations of the firm's profitability and its earnings, as disclosed in its accounting data. From this perspective, hedging makes good sense at first glance. Hedging reduces the amount of "noise" in earnings data that is not due to actions of the managers. That is, hedging increases the informational content about a manager's ability that is conveyed by the firm's reported profits. DeMarzo and Duffie demonstrate that in this situation, the accounting treatment of hedging and the optimal hedging policy are intimately linked. Because managers are better able to gauge the different financial risks the company faces, they have an incentive to hedge these risks to reduce the variability of the firm's earnings and, with that, the variability of their own income stream, which will be linked to the firm's earnings. A manager does not want to face an unexpected currency depreciation that adversely affects the firm's profits.
The disclosure of information, though, interacts with the ability of shareholders to gauge the true ability of a manager. With additional precision, shareholders can make the managers' compensation more sensitive to the firm's performance. To avoid this additional variability in their income, managers may chose not to hedge. If the additional informational content of hedged earnings is sufficiently high, the shareholders may optimally decide not to disclose the firm's hedging activities, to give managers an incentive to hedge.
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