Why Do Insiders Hedge Their Ownership? An Empirical Examination

Abstract

We study derivative instruments that corporate insiders use to diversify and hedge their equity ownership. Our evidence suggests that boards might allow use of these instruments in order to mitigate agency costs associated with overvalued equity and high equity-based pay. These instruments are more likely to be used in place of equity sales when there is greater litigation risk and closer monitoring by the market. Zero-cost collars and variable forwards appear to be timed prior to poor performance. Exchange funds appear to be primarily used for diversification and are associated with higher personal tax rates and closer investment banking ties.

Keywords: Executive compensation, stock awards, stock options, CEO pay, insider ownership, corporate governance, derivative securities, hedging

JEL Classification: G13, G32, G34, J33, M12, M52, M55