Corruption as an Agency Problem – Currency Hedging in Corrupt Countries

Abstract

Risk management should not be the primary concern of a firm operating in an efficient stock market (Modigliani and Miller, 1958). Shareholders can manage their individual risk by holding well-diversified portfolios (Fama, 1980). But managers sometimes operate on the basis that their future earning opportunities will be affected by the continued existence and not necessarily profitability of the firms which they manage, thereby exhibiting agency problems (Coase, 1937; Fama, 1980).  In this paper, it is argued that managers operating in corrupt countries will exhibit greater agency problems by acting contrary to shareholders interest and by seeking less risk at the expense of lower returns (Habib and Zurawicki, 2001). We seek to establish the extent of the agency problem based on the level of currency hedging in which managers engage and we argue that in corrupt countries, all other things equal, more hedging will take place, acting counter to (Modigliani and Miller, 1958), as managers act to preserve their personal wealth, in the form of annual salaries, which is closely tied to firm longevity, rather than firm profitability.