Hedging and Coordinated Risk Management: Evidence from Thrift Conversions

ABSTRACT We provide an explanation for hedging as a means of allocating rather than reducing risk. We argue that when increases in total risk are costly, firms optimally allocate risk by reducing (increasing) exposure to risks that provide zero (positive) economic rents. Our evidence shows that mutual thrifts that convert to stock institutions increase total risk following conversion, consistent with their increased abilities and incentives for risk taking. They achieve this increase by hedging interest‐rate risk and increasing credit risk. We provide some evidence that risk‐management activities are related to growth capacity and management compensation structure attained at conversion.