Managerial Hedging and Incentive Compensation in Stock Market
 Economies

Abstract

Suppose risk-averse managers can hedge the aggregate component of their exposure to firm's cash flow risk by trading in financial markets, but cannot hedge their firm-specific exposure. This gives them incentives to pass up firm-specific projects in favor of standard projects that contain greater aggregate risk. Such risk substitution is a form of moral hazard and it gives rise to excessive aggregate risk in stock markets and excessive correlation of returns across firms and sectors, thereby reducing risk-sharing among stock market investors. An incentive compensation scheme specifying the managerial equity ownership of the firm can be designed to mitigate this moral hazard. We show that the optimal contract might require a dampening of pay-performance sensitivity, whereby managerial ownership is smaller than in absence of this moral hazard. We characterize the resulting endogenous relationship between managerial ownership and (i) the extent of aggregate risk in the firm's cash flows, as well as (ii) firm value. We show that these endogenous relationships can help explain the shape of the empirically documented relationship between ownership and firm performance.