Managerial Incentives, Moral Hazard and Risk Management

Abstract

This paper examines how the structure of managerial compensation is affected by the possibility that managers trade derivatives for a speculation purpose. A simple moral hazard model shows that a strong pay-for-performance sensitivity is ineffective when shareholders cannot monitor the (speculative) use of derivative instruments. Intuitively, while a strong pay-performance sensitivity provides managerial incentives to increase shareholder value by exerting effort, it also creates perverse incentives to increase the firm's cash-flow risks by taking unproductive managerial actions. To test this prediction, I study the effect on the managerial compensation of a new accounting standard, Statement of Financial Accounting Standard No. 133 (FAS 133) which makes it harder for managers to hide the speculative use of derivatives. Following the issuance of FAS 133, derivative users (i.e., firms that traded derivatives before the issuance of FAS 133) increase the sensitivities of their CEO/CFO pay to the firm performance and to the cash-flow risks relative to other firms. Consistent with the model, the evidence suggests that the managerial pay-performance sensitivity is higher when managers cannot conceal information about the use of financial instruments.