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Optimal compensation contracts when managers can hedge

  • Gao, Huasheng
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    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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    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
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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