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Performance Evaluation, Managerial Hedging, and Contract Termination

Author

Listed:
  • Yu Huang

    (Changjiang Industrial and Financial Services Co., Ltd., Shanghai 200122, China)

  • Nengjiu Ju

    (Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University, Shanghai 200030, China)

  • Hao Xing

    (Department of Finance, Questrom School of Business, Boston University, Boston, Massachusetts 02215)

Abstract

We develop a dynamic model where a principal contracts with an agent to operate a firm. The agent, protected by limited liability, trades privately a market portfolio to hedge market risk in his compensation. When liquidation cost of the firm is proportional to its size, the principal manages the termination risk by loading the contract with a positive market component, which alleviates termination risk in normal market conditions but makes termination more likely after negative market shocks. The optimal contract displays a dynamic mixture of absolute and relative performance evaluations and is implemented using a dynamic deferred compensation account.

Suggested Citation

  • Yu Huang & Nengjiu Ju & Hao Xing, 2023. "Performance Evaluation, Managerial Hedging, and Contract Termination," Management Science, INFORMS, vol. 69(8), pages 4953-4971, August.
    • Handle: RePEc:inm:ormnsc:v:69:y:2023:i:8:p:4953-4971
    DOI: 10.1287/mnsc.2022.4533
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