Optimal Contracting with Unobservable Managerial Hedging

49 Pages Posted: 4 Dec 2017

See all articles by Yu Huang

Yu Huang

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Nengjiu Ju

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Hao Xing

Boston University - Questrom School of Business

Date Written: November 29, 2017

Abstract

We develop a continuous-time model where a risk-neutral principal contracts with a CARA manager protected by limited liability to run a project. Its output can be increased by costly unobservable managerial effort, but it is liquidated if the manager quits. The manager can trade a market portfolio in an unobservable private account to hedge market risk in his compensation. New to the literature, our model setup permits compatibility of private saving and hedging, manager's risk aversion, and inefficient project liquidation in one contracting problem. Our optimal contract is a dynamic mixture of relative and absolute performance evaluations. This provides potentially a new explanation to the lack of relative performance evaluation in practice. Moreover, negative market shocks increase project liquidation probability, consistent with the heightened managerial turnover in bad market conditions. Finally, the optimal contract is implemented by risk management accounts, private debt and private equity in an entrepreneurship context.

Keywords: Moral Hazard, Managerial Hedging, Optimal Contracting, Performance Evaluation, Capital Structure

JEL Classification: G11, G12, G32, D82, E2

Suggested Citation

Huang, Yu and Ju, Nengjiu and Xing, Hao, Optimal Contracting with Unobservable Managerial Hedging (November 29, 2017). Available at SSRN: https://ssrn.com/abstract=3079655 or http://dx.doi.org/10.2139/ssrn.3079655

Yu Huang

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Nengjiu Ju (Contact Author)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Hao Xing

Boston University - Questrom School of Business ( email )

595 Commonwealth Avenue
Boston, MA MA 02215
United States

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
104
Abstract Views
987
rank
286,968
PlumX Metrics