Does Hedging Reduce the Cost of Delegation?

I incorporate the choice of hedging instrument into a moral hazard model to study the impact of derivatives on a firm's value. A hedging instrument creates value by minimizing the expected costs of distress. In the model, managers who exert effort on their project understand the underlying risk exposure well and, therefore, can choose the optimal instrument to use as a hedge. I show that the optimal hedging instrument maximizes the firm's value but does not reduce the noise in the compensation contract, thereby forcing investors to leave more rents to the manager. When the agency problem is severe, the investor induces the manager to exert low effort and to choose an imperfect hedge, which leads to a drop in the firm's value. I test the model by exploiting an exogenous shock (the Washington Agreement on Gold, 1999) to the cost of hedging in the gold mining industry and find strong support for the model's predictions.