Risk Management Transparency and Compensation

53 Pages Posted: 25 Jul 2014 Last revised: 24 Aug 2020

See all articles by Chang Mo Kang

Chang Mo Kang

Hanyang University - School of Business

Donghyun Kim

Chung-Ang University

Date Written: August 15, 2020

Abstract

We examine the optimal design of managerial compensation in a setting in which a manager must be induced to maximize shareholder value while managing the firm's cash flow risks. Our model shows that, while high-powered incentive pay (e.g., options) induces the manager to increase shareholder value, it also provides incentives to engage in unproductive risk-seeking activities. This trade-off suggests that transparent disclosures of risk management practices allow shareholders to provide more powerful incentives to the manager. We empirically test this prediction using a regulatory shock, namely, the issuance of Statement of Financial Accounting Standards No. 133 (FAS 133), which improves information disclosure of corporate use of derivatives. We find that FAS 133 enhances the awarding of convex compensation to financial officers who manage and oversee corporate derivative programs. The new standard, however, does not affect compensation for their peer executives (e.g., technical officers) who are unlikely to engage in the operation of derivatives program. Our findings support the optimal contracting hypothesis.

Keywords: managerial compensation, risk management, corporate hedging, financial officers, FAS 133

JEL Classification: J33, M12, G34

Suggested Citation

Kang, Chang Mo and Kim, Donghyun, Risk Management Transparency and Compensation (August 15, 2020). Available at SSRN: https://ssrn.com/abstract=2470480 or http://dx.doi.org/10.2139/ssrn.2470480

Chang Mo Kang (Contact Author)

Hanyang University - School of Business ( email )

222, Wangsimni-ro
Seongdong-gu
Seoul
Korea

Donghyun Kim

Chung-Ang University ( email )

221 Heuksuk-dong
Dongjak-gu
Seoul, 156-756
Korea, Republic of (South Korea)

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