On the strategic value of risk management

• Published in: International journal of industrial organization 2014-11, Vol.37, p.153-169
• Main Authors: Léautier, Thomas-Olivier, Rochet, Jean-Charles
• Format: Article
• Language: English
• Subjects: Commodity market; Competition; Economic models; Economic theory; Game theory; Hedging; Market power; Price and quantity competition; Risk aversion; Risk management; Stockholders; Studies
• ISSN: 0167-7187; 1873-7986
• DOI: 10.1016/j.ijindorg.2014.07.006

This article examines how firms facing volatile input prices and holding some degree of market power in their product market link their risk management and their production or pricing strategies. This issue is relevant in many industries ranging from manufacturing to energy retailing, where firms that are rendered “risk averse” by financial frictions decide on and commit to their hedging strategies before their product market strategies. We find that commitment to hedging modifies the pricing and production strategies of firms. This strategic effect is channeled through the risk-adjusted expected cost, i.e., the expected marginal cost under the probability measure induced by shareholders' “risk aversion”. It has opposite effects depending on the nature of product market competition: commitment to hedging toughens quantity competition while it softens price competition. Finally, not committing to the hedging position can never be an equilibrium outcome: committing is always a best response to non-committing. In the Hotelling model, committing is a dominant strategy for all firms. •We examine firms facing volatile input costs and financial frictions.•Hedging enables them to commit to their aggressiveness on their output markets.•Commitment to hedging has opposite effects depending on the nature of competition.•It toughens quantity competition but softens price competition.