Optimal compensation contracts when managers can hedge

This paper examines optimal compensation contracts when executives can hedge their personal portfolios. In a simple principal-agent framework, I predict that the Chief Executive Officer’s (CEO’s) pay-performance sensitivity decreases with the executivehedging cost. Empirically, I find evidence supporting the model’s prediction. Providing further support for the theory, I show that shareholders also impose a high sensitivity of CEO wealth to stock volatility and increase financial leverage to resolve the executivehedging 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 manager’s ability to hedge the firm’s risk affects governance mechanisms and managerial actions. & 2010 Elsevier B.V. All rights reserved. An executive who hedges is a little bit like the captain of a ship who sees an iceberg up ahead and heads for his lifeboat without waking the sleeping passengers (Louis Lavelle, 2001, p. 70).