Corporate Derivatives as a Manager-Specific Investment

Abstract

This study examines one manager-specific investment, the use of derivatives, and the corresponding market for corporate control. We find firms with large derivatives positions or increases in their unrealized derivatives gains are associated with a significantly lower likelihood of being the target of an acquisition. We further find firms with greater magnitude of derivatives are associated with weaker boards. Consistent with derivatives being used by managers to protect themselves from disciplinary forces, we find the absolute size of firms’ unrealized derivatives value is negatively associated with firm value. Finally, firms with decreasing (increasing) idiosyncratic risk as well as increasing (decreasing) absolute value of changes in derivatives realized gains and losses, exhibit a decreasing (increasing) likelihood of takeovers. In summary, the findings are consistent with derivatives being an example of a manager-specific investment (Shleifer and Vishny (1989)) that is successful at entrenching management.