This paper extends the investigation of the effect of managerial motives on hedging policy. I utilize a proxy variable that incorporates CEO incentives to increase risk relative to incentives to increase stock price. The variable is directly measured using observed characteristics of CEO portfolios of stock and option holdings. Furthermore, CEO risk-taking incentives are modeled as a choice variable to eliminate the simultaneity bias of modeling risk-taking incentives as an exogenous variable. If modeled as a simultaneous system of equations, a strong negative link between CEO risk-taking incentives and the amount of derivative holdings exists. This result is consistent with the notion that derivatives are used for hedging purposes. Both the characteristics of stock and option holdings are important in determining cross-sectional differences in corporate derivative holdings.

There are two tax incentives for corporations to hedge: to increase debt capacity and interest tax deductions, and to reduce expected tax liability if the tax function is convex. We test whether these incentives affect the extent of corporate hedging with derivatives. Using an explicit measure of tax function convexity, we find no evidence that firms hedge in response to tax convexity. Our analysis does, however, indicate that firms hedge to increase debt capacity, with increased tax benefits averaging 1.1 percent of firm value. Our results also indicate that firms hedge because of expected financial distress costs and firm size.