Noise Hedging and Executive Compensation

35 Pages Posted: 23 Aug 2011 Last revised: 18 Sep 2013

Neil A. Doherty

University of Pennsylvania - Insurance & Risk Management Department; University of Pennsylvania - Business & Public Policy Department

James R. Garven

Baylor University - Department of Finance, Insurance & Real Estate

Sven Sinclair

Social Security Administration

Date Written: April 15, 2013

Abstract

We address two apparent paradoxes of risk management: (1) managers hedge in order to avoid negative earnings surprises, yet they tend to hedge risks uninformative of the value of the company; and (2) the presence of options in managers’ compensation distorts their incentive to hedge, inducing them to expose the company to too much risk. Our model is based on informational asymmetry between insiders (managers) and outsiders (investors). Investors derive information about company value from net cash flows (earnings), but the information revealed through earnings depends on the risk management strategy pursued by managers. Fully revealing earnings information is in the investors’ interest, so they design a compensation package to induce managers to make the earnings fully informative. With appropriate assumptions, we show that managers will select the efficient hedge strategy if their compensation includes stock options. Our model also provides a rational explanation for the observed vigorous response of stock prices to modest earnings surprises. Results based upon the analysis of Compustat and Execucomp data provide empirical support for our model; other things equal, firms that offer their CEO’s proportionately higher options-related compensation exhibit stronger stock price responses to changes in earnings and tend to have higher Tobin’s q’s.

Keywords: Employee stock options, Incentives, Executive compensation

JEL Classification: G30, J33, M41

Suggested Citation

Doherty, Neil A. and Garven, James R. and Sinclair, Sven, Noise Hedging and Executive Compensation (April 15, 2013). Available at SSRN: https://ssrn.com/abstract=1915206 or http://dx.doi.org/10.2139/ssrn.1915206

Neil A. Doherty

University of Pennsylvania - Insurance & Risk Management Department ( email )

Philadelphia, PA 19104-6365
United States
215-898-7652 (Phone)
215-898-0310 (Fax)

University of Pennsylvania - Business & Public Policy Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6372
United States

James R. Garven (Contact Author)

Baylor University - Department of Finance, Insurance & Real Estate ( email )

One Bear Place #98004
Baylor University
Waco, TX 76798-8004
United States

HOME PAGE: http://business.baylor.edu/directory/?id=James_Garven

Sven Sinclair

Social Security Administration ( email )

Washington, DC 20254
United States

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