Performance Evaluation, Managerial Hedging, and Contract Termination
66 Pages Posted: 4 Dec 2017 Last revised: 26 Apr 2021
Date Written: April 26, 2021
We develop a dynamic model where a CARA principal contracts with a CARA agent to operate a firm. The agent, protected by limited liability, trades privately a market portfolio to hedge market risk in his compensation. When the liquidation cost of the firm is proportional to its size, principal manages the termination risk by loading the contract with a positive market component which alleviates termination risk in normal market conditions, but makes termination more likely after negative shocks. The optimal contract displays a dynamic mixture of absolute and relative performance evaluations, and is implemented through capital structure featuring a dynamic deferred compensation account.
Keywords: Moral Hazard, Managerial Hedging, Optimal Contracting, Performance Evaluation
JEL Classification: G11, G12, G32, D82, E2
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