University of Southern California Graduate School of Business and Purdue University Krannert School of Management, respectively. We wish to thank Yuk-Shee Chan, Bob Johnson, Rene Stulz, and an anonymous referee for helpful comments on an earlier version of this paper. Remaining errors are our own.
Corporate Risk Management and the Incentive Effects of Debt
Article first published online: 30 APR 2012
1990 The American Finance Association
The Journal of Finance
Volume 45, Issue 5, pages 1673–1686, December 1990
How to Cite
CAMPBELL, T. S. and KRACAW, W. A. (1990), Corporate Risk Management and the Incentive Effects of Debt. The Journal of Finance, 45: 1673–1686. doi: 10.1111/j.1540-6261.1990.tb03736.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
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.