Contracting with Controllable Risk

73 Pages Posted: 11 Jan 2017 Last revised: 19 Feb 2021

See all articles by Chris Armstrong

Chris Armstrong

University of Pennsylvania - Accounting Department

Stephen Glaeser

University of North Carolina (UNC) at Chapel Hill - Accounting Area

Sterling Huang

Singapore Management University - School of Accountancy

Date Written: May 9, 2018

Abstract

We examine how executives’ ability to control their firm’s exposure to risk affects the design of their incentive-compensation contracts. Our natural experimental evidence shows that exchange-traded weather derivatives allow executives to control their firm’s exposure to weather risk. Once these derivatives became available those executives who use them to hedge experience relative reductions in their total compensation and equity incentives. The decline in compensation is consistent with a reduction in the risk premium that executives receive for exposure to weather risk. The decline in equity incentives is consistent with the relation between risk and incentives shifting in a complementary direction when executives can better control their firm’s exposure to risk. Collectively, our findings provide evidence that executives’ ability to control their firms’ exposure, and by extension their own, to an important source of risk influences the design of their incentive-compensation contracts.

Keywords: executive compensation; contract design; equity incentives; risk-taking incentives; stock options; derivatives; hedging; natural experiment; risk management

JEL Classification: G32; J33; J41

Suggested Citation

Armstrong, Chris S. and Glaeser, Stephen and Huang, Sterling, Contracting with Controllable Risk (May 9, 2018). Singapore Management University School of Accountancy Research Paper No. 2017-55, Available at SSRN: https://ssrn.com/abstract=2896147 or http://dx.doi.org/10.2139/ssrn.2896147

Chris S. Armstrong

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Stephen Glaeser

University of North Carolina (UNC) at Chapel Hill - Accounting Area ( email )

McColl Building
Chapel Hill, NC 27599
United States

Sterling Huang (Contact Author)

Singapore Management University - School of Accountancy ( email )

60 Stamford Road
Singapore 178900
Singapore
6808 7929 (Phone)

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