Managerial hedging and portfolio monitoring

Alberto Bisin, Piero Gottardi, Adriano A. Rampini

    Research output: Contribution to journalArticlepeer-review

    Abstract

    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 compensation using financial markets and shareholders can monitor the manager's portfolio in order to keep him from hedging, but monitoring is costly. We find that the optimal incentive compensation and governance provisions have 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 the cost of monitoring is higher 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. Moreover, the model suggests that the optimal level of portfolio monitoring is higher for managers of firms whose performance can be hedged more easily, such as large firms and firms in more developed financial markets.

    Original languageEnglish (US)
    Pages (from-to)158-209
    Number of pages52
    JournalJournal of the European Economic Association
    Volume6
    Issue number1
    DOIs
    StatePublished - Mar 2008

    ASJC Scopus subject areas

    • General Economics, Econometrics and Finance

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