Corporate Risk Management: Evidence from Product Liability

This paper examines corporate incentives for risk management of the high stakes of product liability. We utilize an unexpected increase in the cost of hedging product liability risk to examine the effect of firm characteristics on the decision to hedge. We also examine our group of firms several years after this event to see how the decision to continue to hedge or not impacts firm risk. We find that firms whose performance is more highly correlated with the market are more likely to continue hedging. Leverage also affects hedging and we identify two effects of leverage. One is the effect of a business plan that relies on credit from suppliers, the other is the effect of overall firm leverage. For firms in our sample, significant reliance on credit from business partners increases the probability of hedging while higher debt to equity ratios are associated with lower probability of hedging, consistent with limited liability arguments and the difference between trade credit and general debt. In examining our sample five years after the change in hedging behavior we find that firms that continue to hedge exhibit higher market risk as measured by stock returns than those firms that stop hedging product liability risk. This finding suggests that firms adjust many aspects of firm policy to rebalance exposure to this significant risk.