🤖 AI Summary
This study investigates how firms design internal incentive contracts in the presence of demand and production risks when they can hedge exposure using forward markets. Within a continuous-time CARA framework, the authors jointly solve for optimal production, compensation, and static hedging strategies under both in-house production and delegated agency, integrating a moral hazard principal–agent model with competitive forward market equilibrium. The analysis reveals an interplay between external risk transfer and internal incentives: hedging and delegation act as substitutes in risk sharing, and delegation can enhance firm value even when the agent is more risk-averse and equally productive. Hedging reduces the need for incentive-driven risk exposure, leading to lower optimal hedge ratios and higher equilibrium forward prices under delegation. Numerical experiments confirm the robustness of these findings under demand uncertainty.
📝 Abstract
We study how forward hedging reshapes incentive provision inside the firm. We consider a risk-averse producer facing demand and production risk that can either operate in-house or delegate production to a risk-averse agent under moral hazard, while hedging output in a competitive forward market with a rational market maker. Within a tractable continuous-time CARA framework, we jointly characterize optimal production, compensation, and static hedging in equilibrium. Delegation and external hedging are partial substitutes because both create value through risk sharing. Delegation can increase firm value even when the agent uses the same technology and is more risk averse than the principal, while access to forward hedging reduces the need to provide incentives through risk exposure. This mechanism delivers two main results. First, the principal hedges less under delegation than under in-house production. Second, this lower hedging demand under delegation raises the equilibrium forward price relative to the integrated benchmark. In the constant-demand case, we show that access to hedging lowers the agent's expected compensation under delegation. Numerical results indicate that this mechanism remains robust in the presence of demand uncertainty. More broadly, our results show that external risk transfer through financial markets feeds back into internal organizational design.