How Does Information Asymmetry Affect Corporate Hedging?

Abstract

We test three prominent risk management theories related to information asymmetry that have differing predictions. Exploiting mergers or closures of brokerage firms as plausibly exogenous events that increase information asymmetry, we find that treatment firms significantly reduce derivative-based hedging, compared with matched control firms. Lower hedging is concentrated in firms that are ex ante subject to lower collateral, more financial constraints, and better growth opportunities. Our results are consistent with the view that hedging is constrained by available collateral and, therefore, collateral and financial constraints exacerbated by increasing information asymmetry restrict hedging in affected firms, especially those with attractive investment opportunities. We also find some evidence that treatment firms that have a high-quality CEO and are not subject to collateral constraints respond to the increase in information asymmetry by increasing hedging, consistent with the hypothesis that hedging helps signal superior managerial quality (DeMarzo and Duffie (1991; 1995)).

Keywords: Information asymmetry, collateral, risk management, hedging, analysts

JEL Classification: G30, G32, K22