Abstract
Empirical evidence shows that CEOs are miscalibrated in that they underestimate market risk. We use a standard principal-agent model to investigate how CEO miscalibration influences compensation and hedging. CEOs hedge less as the level of CEO miscalibration increases. Consistent with the CEO miscalibration-compensation literature, the pay-performance sensitivity is positively related to CEO miscalibration. Further, our model predicts that the sensitivity of compensation to CEO miscalibration increases when it is more costly for miscalibrated CEOs to hedge market risk.
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