Why Do Insiders Hedge Their Ownership? An Empirical Examination

Abstract:     
We examine the motivation insiders have to hedge or diversify their equity ownership in the firm using derivative instruments. We document four different types of hedging/diversification instruments used by corporate insiders – zero cost collars, variable forwards, exchange funds, and equity swaps – and test several hypotheses for why insiders would use these instruments. These securities may benefit shareholders by increasing incentives for risk-taking, and through a reduction in agency problems associated with overvalued equity. There is, however, a troublesome aspect to these instruments because they reduce the sensitivity of executive wealth to firm performance, and allow insiders to trade opportunistically on inside information. Our empirical tests reveal little evidence that these securities enhance risk-taking incentives or reduce agency costs of overvalued equity. We find that collar and forward transactions are initiated prior to poor performance which suggests that these two particular strategies are used by insiders to trade on insider information. In contrast, we do not find that the use of exchange funds is associated with poor performance which is consistent with this instrument being used primarily for diversification. Understanding the use of these securities is important not only to research on corporate governance and managerial incentives but also to research on insider trading.trading.

Number of Pages in PDF File: 58

Keywords: hedging, derivatives, insider trading, managerial incentives, ownership

JEL Classification: G30, G31

working papers series