Managerial Career Concerns and Risk Management

ABSTRACT We present a dynamic model of corporate risk management and managerial career concerns. We show that managers with low (high) initial reputation have high (low) career concerns about keeping their jobs and receiving all future income. These managers are more likely to speculate (hedge) early in their careers. In the later stage of their careers when managers have less career concerns, there is no speculative motive for self interested managers. On the other hand, highly reputable managers have minimal career concerns and they engage in neither hedging nor speculation early in their careers, but they may choose to hedge after poor early performance. INTRODUCTION In the classic frictionless world as in Modigliani and Miller (1958), financial risk management is just one type of financing activities. Such financing activities only change the distribution of firm value among various claim holders but do not affect the total value of the firm. Since shareholders of the firm can achieve their goal of reducing systematic risk by holding a diversified portfolio, corporate risk management neither increases nor decreases shareholders' welfare. If risk management bears a cost, it is a strictly value-reducing activity. Therefore, the classical paradigm suggests that corporate managers should not engage in any risk management activities at all. However, the increasing use of derivatives by corporations appears to contradict this prediction. In this article, we use a dynamic model to provide some insights on the motivation of managers to hedge or speculate at various points of their careers. In our model, there are good managers and bad managers. The manager's true ability is her own private information, and the compensation contract is a short-term contract revised by the shareholders to reflect the perceived reputation of the manager at the time of revision. In this model, the firm also faces a takeover threat by a corporate raider who is taking over firms with bad managers. Without knowing the true type of the manager, the raider makes the takeover decision based on the perceived managerial reputation. Once the firm is taken over, the manager loses her job, future wage income, and any other firm-specific rent. The prospect of losing the job and any future income with the job is the managerial career concern that we are interested in this article. In each period, there is a cash flow signal, which the manager can manipulate through hedging or speculation. The action of hedging or speculation is a private action conducted by the manager, not observable to the others but rationally anticipated by the shareholders and the corporate raider. We show that the manager would like to hedge or speculate to enhance her probability of survival and her compensation, both current and future. We contribute to the literature of corporate risk management by studying how the reputation of a manager affects her career concerns at different career stages and in turn affects the activities of hedging and speculation. We show that a manager with medium initial reputation is concerned about continuing her employment and is likely to hedge early in her career. Later in her career, her hedging activities decrease. This result is consistent with the empirical evidence provided by Tufano (1996). Our model also provides several novel empirical predictions. Because a manager with low initial reputation must produce really good results to convince shareholders and outsiders of her quality or lose her job otherwise, such high career concern leads her to speculate early in her career. Over time, since a bad manager is more likely to lose her job, the pool of surviving managers consists of more good managers. This effect results in an increasing relation between a manager's reputation and her tenure. The longer the tenure, the higher her reputation becomes, and the less the speculative motive is. …