Corporate managers devote enormous resources and ingenuity to trying to influence investors’ and analysts’ perceptions of their firms’ quality. Outsiders’ perceptions can be influenced by managers in many ways, such as the choice of accounting standard, or the content and timing of disclosures. In Discussion Paper No. 1520, François Degeorge, Boaz Moselle and Richard Zeckhauser examine what level of corporate risk managers will choose in order to affect market perceptions when they have private information on the quality of their firm, and when they may not be faithful agents of the shareholders.

Good firms may have an incentive to engage in low-risk activities, in which their performance will reveal their true ability. Bad firms may prefer riskier ventures, in which the performance signal is noisy, and hence they do not disclose as much about their type. The authors show that the level of corporate risk depends crucially on two factors. The first is whether the choice of the risk level is observable. When this is the case, firms cannot manipulate variance, and bad firms have a stronger incentive to mimic the good firms’ choice of risk. The second factor is the distribution of types in the population. Here, the intuition is that if one good firm is surrounded by many bad firms, its reputation is initially tarnished by the presence of its poor-quality neighbours; therefore, it may find the situation unbearable and prefer to take risks in order to achieve a higher level of performance which will distinguish it from its neighbours. Conversely, a bad firm among many good firms may be quite content with the market’s prior beliefs, and may prefer to pursue safe strategies. The paper tests the predictions of the model using US data, and confirms the theoretical results when the choice of risk is not fully observed.

Hedging and Gambling: Corporate Risk Choice When Informing the Market
François Degeorge, Boaz Moselle and Richard Zeckhauser