We use estimates of the Black-Scholes sensitivity of managers' stock option portfolios to stock return volatility and the sensitivity of managers' stock and stock option portfolios to stock price to test the relationship between managers' risk preferences and hedging activities. We find that as the sensitivity of managers' stock and stock option portfolios to stock price increases, firms tend to hedge more. However, as the sensitivity of managers' stock option portfolios to stock return volatility increases, firms tend to hedge less. ONE OF THE AGENCY COSTS associated with the corporate form of ownership comes from the risk aversion of the firm's managers. The typical corporate manager has a significant portion of his or her wealth invested in the corporation, both through portfolio holdings and the value of firm-specific human capital. As a result, managers have an incentive to reduce firm risk more than may be desirable from the perspective of an unaffiliated, diversified shareholder. One way to mitigate managerial risk aversion is to provide the manager with contracts that have a payoff structure that is a convex function of the firm's stock price~Smith and Stulz~1985!!. Guay~1999! finds that stock options are an important way in which convexity is added to managers' portfolios.However, as recognized by Carpenter~2000! and Lambert, Larcker, and Verrecchia~1991!, stock options create two opposing effects on managerial incentives. The first effect is sensitivity to stock return volatility. Due to the convex payoff structure of options, the value of a manager's stock option portfolio increases with the volatility of the firm's stock returns. This sensitivity to stock return volatility should, ceteris paribus, give the manager an incentive to take more risk. The second effect is sensitivity to stock price. This effect comes from the direct link between the payoff of an option and

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We investigate the relationship between derivatives use and the extent of asymmetric information faced by the firm. Using alternative analyst forecast proxies for asymmetric information, we find evidence that both the use of derivatives and the extent of derivatives usage is associated with lower asymmetric information. Specifically, for firms using derivatives (notably currency derivatives) we find that analysts' earnings forecasts have significantly greater accuracy and lower dispersion. These findings support the conjectures of DeMarzo and Duffie (1995) and Breeden and Viswanathan (1998) who argue that hedging reduces noise related to exogenous factors and hence decreases the level of asymmetric information regarding a firm's earnings.

In this study we use estimates of the sensitivities of managers' portfolios to stock return volatility and stock price to directly test the relationship between managerial incentives to bear risk and two important corporate decisions. We find that as the sensitivity of managers' stock option portfolios to stock return volatility increases firms tend to choose higher debt ratios and make higher levels of R&D investment. These results are even stronger in a subsample of firms with relatively low outside monitoring. For these firms, managerial incentives to bear risk play a particularly pivotal role in determining leverage and R&D investment.