Optimal Compensation Contract When Managers Can Hedge

Abstract

This paper examines optimal compensation contracts when executives can hedge their personal portfolios. In a simple principal-agent framework, I predict that the CEO's pay-performance sensitivity decreases with the executive hedging cost. Empirically, I find evidence supporting the model's prediction. Providing further support for the theory, I show that shareholders also impose high sensitivity of CEO wealth to stock volatility via compensation contracts when managers can hedge. In addition to providing higher-power contracts, shareholders increase financial leverage to resolve the executive-hedging problem. Moreover, executives with lower hedging costs hold more exercisable in-the-money options, have weaker incentives to cut dividends, and pursue fewer corporate diversification initiatives. Overall, the ability to hedge firm risk undermines executive incentive and enables managers to bear more risk, thus affecting governance mechanisms and managerial actions.