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What Drives Actual Hedging Behaviour? Developing Risk Management Instruments

In the last forty years economists have made great progress in developing optimal risk management strategies. Various authors have formulated optimal hedging models that maximise the decision maker’s utility by explicitly taking the risk-return tradeoff into account. While these models seem helpful, the actual behaviour of firms does not seem in line with the optimal strategies proposed by the models. This mismatch is partly caused by neglecting alternative motivations to hedge. In this chapter I show the relationship between the firm’s focus on shareholder value and hedging behaviour. Furthermore, this mismatch is caused by neglecting the beliefs and perceptions structure of managers. This mismatch between optimal and actual risk management behaviour has great consequences for firms facing risk, as well as for financial institutions, such as banks and exchanges, attempting to develop risk management policies. A product-development model for risk management services is proposed that integrates the findings of behavioural decision-making models and optimal hedging models.