Risk Management, Executive Compensation and the Cross-Section of Corporate Earnings∗

This paper presents a theory of risk management in which the choices of managers over effort and risk are imperfectly monitored by outsiders. In a principal-agent framework, risk management can reduce extraneous noise in the variables outsiders observe or create opportunities for self-dealing behavior. Solving this trade-off, the analysis characterizes which events should be hedged and how executive compensation can give the right incentives to do so. The model rationalizes several empirical features commonly described as anomalous, in an optimal-contract setting. In equilibrium, the distribution of hedged earnings is hump-shaped with asymmetric tails even though the production technology does not exhibit such features. Further, the model can predict an S-shaped response of the stock price to current earnings. The model accounts for the prevalence of linear compensation schemes and the relatively low performance-pay observed in managerial jobs. Empirical implications for risk controls and the detection of earnings management are also examined.