Do Firms Hedge Optimally? Evidence from an Exogenous Governance Change

Abstract

We ask whether firms hedge optimally by analyzing the impact the NYSE/NASDAQ listing rule changes have had, which exogenously imposed board composition changes on a subset of firms, on financial risk management. Using new proxies for the extent of financial risk management in non-financial firms we find that treated firms reduce their financial hedging, in a difference-in-difference framework. The reduction is concentrated in firms with higher conflicts of interests, such as a high CEO equity ownership level, which exposes them to more idiosyncratic risk, and a higher occurrence of option backdating. We reject the hypothesis that newly majority-independent boards reduce financial hedging due to a lack of knowledge. First, we find no difference in financial hedging for firms where SOX mandated the addition of a financial expert relative to those that already had such expertise. Second, shareholder value increases more during the period of time of the listing rule deliberations for treated firms that hedge prior to the treatment. We conclude that some firms hedge too much reducing shareholder value potentially to the benefit of under-diversified CEOs. We also show that board independence serves to reinforce monitoring which allows boards to cut back on excessive financial hedging.