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Managerial Hedging and Portfolio Monitoring

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Author Info
Alberto Bisin ()
Piero Gottardi ()
Adriano A. Rampini ()

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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 GmbH in its series CESifo Working Paper Series with number CESifo Working Paper No. 1322.

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

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Related research
Keywords: executive compensation incentives monitoring corporate governance.

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
G30 - Financial Economics - - Corporate Finance and Governance - - - General

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Reich, S., 2007. "Robust Incentives," Cambridge Working Papers in Economics 0729, Faculty of Economics, University of Cambridge. [Downloadable!]
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