Finance theory does not provide a comprehensive framework for explaining risk management within the imperfect financial environment in which firms operate. Corporate managers, however, rank risk management as one of their most important objectives. Therefore, it is not surprising that papers on the question why firms hedge are mushrooming. This paper critically reviews this literature and analyses the implications for risk management practice. It is distinguished between two competing approaches to corporate hedging: equity value maximising strategies and strategies determined by managerial risk aversion. The first category suggests that managers act in the best interest of shareholders. They hedge to reduce real costs like taxes, costs of financial distress and costs of external finance or to replace home-made hedging by shareholders. The second category considers that managers maximise their personal utility rather than the market value of equity. Their hedging strategy, therefore, is determined by their compensation plan and reputational concerns.
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