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)
AFA 2006 Boston Meetings Paper
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 can only imperfectly monitor the manager's portfolio in order to keep him from hedging the risk in his compensation. We find that the optimal contract implies incentive compensation and governance provisions with 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 monitoring is more costly 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.
Keywords: Executive Compensation, Incentives, Monitoring, Corporate Governance
JEL Classification: G30, D82working papers series
Date posted: February 27, 2005
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