Douglas Breeden
Duke University, Durham, NC 27708
S. Viswanathan
Duke University, Durham, NC 27708
ABSTRACT
We present an asymmetric information model of hedging that has the intuition that hedging is undertaken by higher ability managers who wish to "lock-in" the higher profits that result from their higher ability. Thus, hedging is an attempt to improve the informativeness of the learning process. We analyze two models. We first analyze a model where managers care only about their reputations. In this case, we show that an intuitive equilibrium that involves hedging by higher ability managers always exists. Lower ability mangers also hedge when differences in abilities are low but do not hedge when differences in abilities are high. We consider a second model where mangers hold equity in the firm in addition to caring for their managerial reputations. The presence of FDIC insurance or pre-existing debt makes hedging costly to equityholders as it is a variance reducing activity. However, this cost of hedging is lower for higher ability mangers. This leads to both kinds of mangers not hedging when the difference in ability is low. At higher differences in ability, the intuitive equilibrium in which the higher ability manger hedges exists. In this equilibrium, greater separation occurs relative to the case where mangers were only concerned about their reputations.