Contracting with Controllable Risk
73 Pages Posted: 11 Jan 2017 Last revised: 19 Feb 2021
Date Written: May 9, 2018
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: Suggested Citation