Residual foreign exchange risk: does CEO compensation matter?

Purpose - The purpose of this paper is to investigate whether CEO compensation scheme may induce some agency conflicts in the foreign exchange risk hedging policy. Design/methodology/approach - Residual exposure is a post-hedging variable computed as the ratio of unrealized foreign exchange risk gains/losses to international sales. The authors follow the optimal hedging theory developed bySmith and Stulz (1985). The residual foreign exchange risk exposure is a way to capture some consequences of the managerial risk aversion, whereas the compensation scheme granted to CEO reveals that of the shareholders. The authors interpret any deviation to the predictions of this theory as a mark that some agency conflicts exist. Findings - CEO compensation (stock-options, shares and so) significantly influence the level of the residual foreign exchange risk exposure. Both in-the-money exercisable options and shares are negatively related to the residual exposure of foreign exchange risk. The authors also document that the effect of agency problems is rather contingent because shares and options have especially a negative impact when the level of foreign exchange risk is relatively high. Originality/value - The residual FX risk exposure variable the authors promote in this paper completes the traditional proxies used to depict the corporate hedging policy such as the nominal or total fair value of currency derivatives (Davieset al., 2006), use of nominal values (Spanò, 2007), use of fair values of derivatives and the fraction of production hedged (Wang and Fan, 2011). The information that it conveys differs significantly from the one provided by traditional proxies because it captures the year-end post hedging firm’s risk profile.