Optimal compensation contracts when managers can hedge |
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Authors: | Huasheng Gao |
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Institution: | Nanyang Business School, Nanyang Technological University, S3-B1A-06, 50 Nanyang Avenue, Singapore 639798, Singapore |
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Abstract: | This paper examines optimal compensation contracts when executives can hedge their personal portfolios. In a simple principal-agent framework, I predict that the Chief Executive Officer's (CEO's) pay-performance sensitivity decreases with the executive-hedging cost. Empirically, I find evidence supporting the model's prediction. Providing further support for the theory, I show that shareholders also impose a high sensitivity of CEO wealth to stock volatility and increase financial leverage to resolve the executive-hedging problem. Moreover, executives with lower hedging costs hold more exercisable in-the-money options, have weaker incentives to cut dividends, and pursue fewer corporate diversification initiatives. Overall, the manager's ability to hedge the firm's risk affects governance mechanisms and managerial actions. |
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Keywords: | G32 J33 J41 |
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