Risk measurement and hedging: With and without derivatives

This paper examines a setting in which the derivatives strategies of two fi rms are known, but completely different. One firm aggressively hedges its r isk using derivatives. The other firm uses a combination of operating and f inancial decisions, but no derivatives, to manage its risk. The different c hoice of methods is a result of different abilities to adjust operating cos ts and different needs for investment capital. Managerial incentives also p lay a role. Although risk-averse managers have an incentive to reduce risk, how and how much they hedge depends on how they are compensated.