We use estimates of the Black-Scholes sensitivity of managers' stock option portfolios to stock return volatility and the sensitivity of managers' stock and stock option portfolios to stock price to test the relationship between managers' risk preferences and hedging activities. We find that as the sensitivity of managers' stock and stock option portfolios to stock price increases, firms tend to hedge more. However, as the sensitivity of managers' stock option portfolios to stock return volatility increases, firms tend to hedge less. ONE OF THE AGENCY COSTS associated with the corporate form of ownership comes from the risk aversion of the firm's managers. The typical corporate manager has a significant portion of his or her wealth invested in the corporation, both through portfolio holdings and the value of firm-specific human capital. As a result, managers have an incentive to reduce firm risk more than may be desirable from the perspective of an unaffiliated, diversified shareholder. One way to mitigate managerial risk aversion is to provide the manager with contracts that have a payoff structure that is a convex function of the firm's stock price~Smith and Stulz~1985!!. Guay~1999! finds that stock options are an important way in which convexity is added to managers' portfolios.However, as recognized by Carpenter~2000! and Lambert, Larcker, and Verrecchia~1991!, stock options create two opposing effects on managerial incentives. The first effect is sensitivity to stock return volatility. Due to the convex payoff structure of options, the value of a manager's stock option portfolio increases with the volatility of the firm's stock returns. This sensitivity to stock return volatility should, ceteris paribus, give the manager an incentive to take more risk. The second effect is sensitivity to stock price. This effect comes from the direct link between the payoff of an option and

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Sweden has a high degree of separation of ownership from control through pyramids, dual-class shares, and cross-holdings. This increases the potential for private benefits of control. However, Sweden's extralegal institutions—tax compliance and newspaper circulation—are consistent with greater shareholder protection. Using data on Swedish mergers we find limited evidence of shareholder expropriation. Apparently, Sweden's extralegal institutions offset the drawback of weak corporate governance.

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In this study we use direct estimates of the portfolio diversification of the largest shareholder in a firm to study the impact of shareholder diversification on the firm. For firms where the controlling shareholder is an individual, our tests indicate that the owner-managers use debt, dual class shares and corporate control transactions (merger activity) to strategically trade off corporate control and the drawback of poor portfolio diversification. However, for firms where the controlling shareholder is an institution, our results indicate that control but not diversification is important. Copyright 2007 The Authors Journal compilation (c) 2007 Blackwell Publishing Ltd.