We provide an explanation for hedging as a means of allocating rather than reducing risk. We argue that when increases in total risk are costly, firms optimally allocate risk by reducing~increasing! exposure to risks that provide zero~positive! economic rents. Our evidence shows that mutual thrifts that convert to stock institutions increase total risk following conversion, consistent with their increased abilities and incentives for risk taking. They achieve this increase by hedging interestrate risk and increasing credit risk. We provide some evidence that risk-management activities are related to growth capacity and management compensation structure attained at conversion.CURRENT RISK-MANAGEMENT LITERATURE focuses on identifying equilibrium scenarios in which a firm minimizes the total variability of its cash f lows~e.g., Smith and Stulz~1985! and Froot, Scharfstein, and Stein~1993!!. In these models, the role of risk management is to mitigate the costs associated with cash f low volatility that result from capital market imperfections, thus creating value for shareholders. However, the existing models do not specify the source of variance in the distribution of firms' cash f lows. They focus only on the benefits of risk management for reducing the total risk of a firm's portfolio. Consequently, these models ignore multidimensional risks and the possible covariation among risks within a firm.By contrast, this paper argues that firms can use risk management to allocate the firm's total risk exposure among multiple sources of risk, rather than to reduce total risk. We consider the case where multiple sources of risk are bundled together in a single asset or liability and firms are unable to acquire these risks separately in the spot markets. Stulz~the editor!, and an anonymous referee were especially useful. We are grateful to the Office of Thrift Supervision for providing data. 1 The existence of multidimensionality in total firm risk is well acknowledged in the literature~e.g., Smith~1995!!. For example, investment in a single project might expose a firm to such risks as input and output price risk, foreign exchange rate risk, interest-rate risk, credit risk, liquidity risk, market risk, or political risk. THE JOURNAL OF FINANCE • VOL LIII, NO. 3 • JUNE 1998 979 then the firm's portfolio problem is constrained because a change in any one source of risk simultaneously affects other risks. Firms, however, can effectively unbundle risks using various cash market or derivative instruments. Given bundled risks, we are able to explain optimal risk reduction or hedging of certain risks even for firms attempting to increase total firm risk.Specific predictions about optimal risk allocation require structure on the definition of "risk." We segregate risk into two types based on a firm's information advantage with respect to the source of risk. Firms earn rents or economic profits for bearing risk related to activities in which the firm has a comparative information advantage~core-business risk!. By contrast, firms ...
