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Optimal compensation contracts when managers can hedge

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  • Gao, Huasheng

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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  • Gao, Huasheng, 2010. "Optimal compensation contracts when managers can hedge," Journal of Financial Economics, Elsevier, vol. 97(2), pages 218-238, August.
    • Handle: RePEc:eee:jfinec:v:97:y:2010:i:2:p:218-238
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