Financial innovations and managerial incentive contracting

Abstract.  The top executives' demands for financial instruments that enable them to hedge the risk exposure in their compensation has increased drastically in the last decade. We analyse the implications of a manager's hedging ability for effort incentives. We show that if the manager's hedging opportunity is limited to a known fixed number of trading rounds with risk‐neutral third parties, then the equilibrium effort is not affected at all. If the manager has the opportunity to hedge without committing to a last trading round, however, she hedges completely and no effort incentives can be sustained. Therefore, limiting the manager's opportunity to hedge to a fixed known number of trading rounds is crucial for sustaining incentives. JEL classification: G30, G32     

ACQUISITION OF INFORMATION TO DIVERSIFY CONTRACTUAL RISK*

Are hedging transactions that diversify a manager’s compensation risk detrimental to incentives, or can they improve contracting efficiency? If hedging provides efficiency benefits, should the manager or the firm undertake it? In our model, both the firm and the manager can trade financial portfolios to diversify the manager’s compensation risk. Prior to the portfolio selection, the parties need to acquire information on how different financial portfolios fit their diversification purposes. We illustrate that financial portfolios correlated with firm‐specific risk improve contracting efficiency. For equal information costs, it is optimal for the firm to undertake the hedging on the manager’s behalf.     

Risk sharing,risk shifting and the role of convertible debt

This paper considers a financial contracting problem between a risk neutral entrepreneur and a risk averse investor. Once the venture is started, the entrepreneur chooses an action that determines the riskiness of the venture’s payoff. When action choice is contractible, the optimal risk sharing consideration under limited liability calls for a pure debt contract and the low risk action is adopted. When the action choice is not contractible, due to the risk shifting problem implementing the low risk action requires a deviation from the optimal risk sharing. I focus on situations where despite this deviation, the risk averse investor prefers to implement the low risk action and show that a convertible debt contract is superior to pure debt, pure equity and any mixture of debt and equity.     

Stock recommendation of an analyst who trades on own account

This article analyzes the provision of information acquisition and truthful reporting incentives to a financial analyst who can privately trade on own account. In a binary message and state space, I show that the analyst's reward scheme essentially provides him with a portfolio endowment traded in the market. Regardless of the true signal, the analyst issues the report that corresponds to the portfolio endowment with maximum market value, given security prices. The analyst's information acquisition incentive is driven only by private portfolio considerations: he acquires information only if he will be holding a large enough position in the stock he covers.     

Equilibrium Incentives to Acquire Precise Information in Delegated Portfolio Management

This paper investigates how a linear contract offered to a portfolio manager affects her incentives to acquire precise information. I show that increasing the manager's portfolio share increases her demand for precise information. This result contrasts with the existing irrelevance results where the manager's portfolio share does not affect her precision choice. The irrelevance result relies on the manager facing a constant asset price, regardless of her demand. In a noisy rational expectations framework, increasing the manager's share decreases her demand and results in a less informative asset price. Thus, the manager gathers more precise information when offered a larger fraction of portfolio returns.     

Tariff Discrimination versus MFN under Incomplete Information

This paper presents a model of legal migration of temporary skilled workers from one source country to two host countries, both of which can control their levels of such immigration. Because of complementarities between capital and labor, the return on capital is positively related to the level of immigration. Consequently, when capital is immobile, host nations' optimal levels of immigration are positively related to their capital endowments. Further, when capital is mobile between the host nations, the common return on capital is a function of the levels of immigration in both countries, meaning that immigration is a public good. As a result, when immigration imposes costs on host countries, the Nash equilibrium results in free riding and less immigration than would occur in the cooperative equilibrium. These results are qualitatively unaltered when capital mobility extends to the source nation.     

Implications of Executive Hedge Markets for Firm Value Maximization

This paper analyzes the incentive implications of executive hedge markets. The manager can promise the return from his shares to third parties in exchange for a fixed payment—swap contracts—and/or he can trade a customized security correlated with his firm-specific risk. The customized security improves incentives by diversifying the manager's firm-specific risk. However, unless they are exclusive, swap contracts lead to a complete unraveling of incentives. When security customization is sufficiently high, the manager only trades the customized security—but not any nonexclusive swap contracts, and incentives improve. Access to highly customized hedge securities and/or exclusive swap contracts increases the manager's pay-performance sensitivity .     

Bargaining and exclusivity in a borrower–lender relationship

This paper presents a stylized model of a borrower–lender relationship where funds are gradually invested in a project with uncertain return. We show that an exclusive financing relationship arises endogenously in equilibrium due to initial lender’s superior information on the project’s progress. The analysis also identifies a novel distortionary effect of exclusivity and the consequent loss of future rents on the ex-ante choices of the borrower. When she chooses the amount of funds to be initially invested in the project, the borrower chooses to overinvest making the future rent extraction by the initial lender as costly as possible. We would like to thank Alberto Bisin, Andrew Chen, Boyan Jovanovic, Hideo Konishi, David Mauer, Efe Ok, Mike Riordan, Charles A. Wilson, and seminar participants at Society of Economic Design 2002 meetings in New York and Southern Methodist University for helpful comments. The usual disclaimer applies.     

Managerial risk reduction, incentives and firm value

Summary. Empirical evidence suggests that managers privately alter the risk in their compensation by trading in the financial markets. This paper analyzes the implications of the managers hedging ability on her optimal compensation scheme, incentives and firm value. I allow the manager to reduce her systematic risk exposure by trading the market portfolio. I find that the managers optimal hedge depends on the liquidity of the market. Due to imperfect liquidity, the managers optimal hedge is not complete. The equilibrium pay-performance sensitivity and hence the managers equilibrium incentives and the firm value increases in the liquidity of the market.Received: 24 November 2003, Revised: 22 September 2004, JEL Classification Numbers: G30, G32.I am grateful to a referee whose comments improved the paper. I would also like to thank Gerald Garvey and Li Jin for their helpful comments on an earlier draft.     

Direct sale of information when precision is unobservable

Abstract.  This paper studies the incentives of an information seller to provide precise information when precision is not observable and investors with rational expectations can extract information from the equilibrium asset price. I show that the seller can verify her precision by employing a non‐linear contract. I derive the equilibrium fee for information as a function of the seller's incentives, the sales volume, and buyers' trading intensity. I also analyse the implications of allowing the seller to trade on her own account for truthfulness and precision choice. JEL Classification: G11, G14, D42