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Optimal compensation contracts when managers can hedge

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  • Gao, Huasheng
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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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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 97 (2010)
    Issue (Month): 2 (August)
    Pages: 218-238

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    Handle: RePEc:eee:jfinec:v:97:y:2010:i:2:p:218-238

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Executive compensation Hedging Equity incentives;

    References

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    Cited by:
    1. Hung, Mao-Wei & Liu, Yu-Jane & Tsai, Chia-Fen, 2012. "Managerial personal diversification and portfolio equity incentives," Journal of Corporate Finance, Elsevier, vol. 18(1), pages 38-64.

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