Costly Managerial Hedging, Market Liquidity and Firm Value

Abstract

Empirical evidence suggests that managers hedge the systematic risk in their compensation by trading in the financial markets. This paper analyzes the implications of the manager's hedging ability on her optimal compensation scheme, incentives and firm value. We allow the manager to adjust her systematic risk exposure by trading the market portfolio. We find that; (i) the manager's optimal hedge depends on the liquidity of the market. With imperfect liquidity, the manager's optimal hedge is not complete and she bears some systematic risk. (ii) The equilibrium pay-performance sensitivity is decreasing in the market risk and increasing in the market liquidity. (iii) Since better hedging ability increases the manager's equilibrium incentives, the firm value increases in the liquidity of the market where systematic risk is traded. This last result contrasts with previous studies that suggest a negative relationship between stock market liquidity and production efficiency.