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Managerial Hedging and Portfolio Monitoring

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  • Alberto Bisin
  • Piero Gottardi
  • Adriano A. Rampini

Abstract

Incentive compensation induces correlation between the portfolio of managers and the cash flow of the firms they manage. This correlation exposes managers to risk and hence gives them an incentive to hedge against the poor performance of their firms. We study the agency problem between shareholders and a manager when the manager can hedge his incentive compensation using financial markets and shareholders cannot perfectly monitor the manager’s portfolio in order to keep him from hedging the risk in his compensation. In particular, shareholders can monitor the manager’s portfolio stochastically, and since monitoring is costly governance is imperfect. If managerial hedging is detected, shareholders can seize the payoffs of the manager’s trades. We show that at the optimal contract: (i) the manager’s portfolio is monitored only when the firm performs poorly, (ii) the more costly monitoring is, the more sensitive is the manager’s compensation to firm performance, and (iii)conditional on the firm’s performance, the manager’s compensation is lower when his portfolio is monitored, even if no hedging is revealed by monitoring.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1322.

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Date of creation: 2004
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Handle: RePEc:ces:ceswps:_1322

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Keywords: executive compensation; incentives; monitoring; corporate governance.;

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Cited by:
  1. Avdjiev, Stefan & Zeng, Zheng, 2009. "Impact of heterogeneous managerial productivity on executive hedge markets in an asymmetric information environment," Finance Research Letters, Elsevier, Elsevier, vol. 6(4), pages 187-201, December.
  2. Papa, Gianluca & Speciale, Biagio, 2011. "Financial leverage and managerial compensation: Evidence from the UK," Research in Economics, Elsevier, vol. 65(1), pages 36-46, March.
  3. Bisin, Alberto & Guaitoli, Danilo, 2012. "Information extraction and norms of mutual protection," Journal of Economic Behavior & Organization, Elsevier, vol. 84(1), pages 154-162.
  4. Guido Ruta & Piero Gottardi, 2009. "Equilibrium corporate finance," 2009 Meeting Papers, Society for Economic Dynamics 149, Society for Economic Dynamics.
  5. Reich, S., 2007. "Robust Incentives," Cambridge Working Papers in Economics 0729, Faculty of Economics, University of Cambridge.
  6. Luigi Iovino, 2012. "Sophisticated Intermediation and Aggregate Volatility," 2012 Meeting Papers, Society for Economic Dynamics 965, Society for Economic Dynamics.
  7. Gao, Huasheng, 2010. "Optimal compensation contracts when managers can hedge," Journal of Financial Economics, Elsevier, vol. 97(2), pages 218-238, August.

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