Managerial Hedging and Portfolio Monitoring
Adriano A. Rampini
New York University - Leonard N. Stern School of Business - Department of Economics
European University Institute - Department of Economics; Ca Foscari University of Venice - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute for Economic Research)
December 1, 2006
CESifo Working Paper Series No. 1322
University Ca' Foscari of Venice, Dept. of Economics Research Paper Series No. 24/07
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 compensation using financial markets and shareholders can monitor the manager's portfolio in order to keep him from hedging, but monitoring is costly. We find that the optimal incentive compensation and governance provisions have the following properties: (i) the manager's portfolio is monitored only when the firm performs poorly, (ii) the manager's compensation is more sensitive to firm performance when the cost of monitoring is higher or when hedging markets are more developed, 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. Moreover, the model suggests that the optimal level of portfolio monitoring is higher for managers of firms whose performance can be hedged more easily, such as larger firms and firms in more developed financial markets.
Number of Pages in PDF File: 53
Keywords: Executive compensation, incentives, monitoring, corporate governance
JEL Classification: G30, D82working papers series
Date posted: November 13, 2004
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