Managerial Hedging and Portfolio Monitoring∗

Incentive compensation induces correlation between the portfolio of managers and the cash flow of the firms they manage. This correlation exposes managers to risk and hence gives them an incentive to hedge against the poor performance of their firms. We study the agency problem between shareholders and a manager when the manager can hedge his incentive compensation using financial markets and shareholders can only imperfectly monitor the manager’s portfolio in order to keep him from hedging the risk in his compensation. We find that the optimal contract implies incentive compensation and governance provisions with the following properties: (i) the manager’s portfolio is monitored only when the firm performs poorly, (ii) the manager’s compensation is more sensitive to firm performance when monitoring is more costly or when hedging markets are more developed, and (iii) conditional on the firm’s performance, the manager’s compensation is lower when his portfolio is monitored, even if no hedging is revealed by monitoring. JEL: G30; D82