Part of the “economic risk” are the financial risks faced by corporations. Many corporations manage their financial risks, such as interest rate, exchange rate and commodity price risks, using derivative securities. Recently, firms have also been concerned about credit risks and refinancing (liquidity) risks. The use of financial derivatives is especially prevalent among German firms. Bodnar and Gebhardt (1999) report that 78% of German firms use derivatives compared to 57% of firms in the USA. An important area in corporate finance is to understand why and how firms are using derivatives, and how derivatives policies affect total firm risk and firm value. While there is a large theoretical literature that has derived conditions under which hedging with derivatives increases shareholder wealth, empirical studies document a considerable divergence between the theory and the practice of hedging. Glaum (2002) finds that a majority of German firms follow profit-oriented, forecast-based hedging strategies, which is inconsistent with the traditional theories of corporate risk management. High-profile derivatives related losses at major companies in Europe, the USA, Asia, and Africa demonstrate the need to understand corporate risk management practices not only from a shareholder perspective but also from the perspective of regulators and other stakeholders of corporations. The objective of this research project is to examine whether behavioral explanations, which either assume that a rational manager operates in an irrational market, or an irrational manager operates in a rational market, better explain current risk management practices.
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