Ebook On managerial risk-taking incentives when compensation may be hedged against
In this note we examine incentive effects of managerial compensation on managerial risk taking when that compensation can be partially hedged against. Ross (2004) performs a detailed analysis of incentive effects of nonlinear contracts on risk-averse managers when there is no possibility of hedging. In particular, he identifies three effects of the compensation form on the incentives: convexity, magnification and translation effect.
The combination of the three determines whether the manager will act more or less aggressively. That paper complements the work of Carpenter (2000), who also noted, in a dynamic setting, that convex payoffs need not increase managerial appetite for risk. Also in a dynamic model, we focus on another dimension influencing the manager’s risk preferences, namely the possibility of hedging. In particular, it is of interest to study how much higher risk-taking the possibility of hedging will induce, if at all. Most of our analysis is restricted to the case of CARA preferences, for tractability reasons, but also because it eliminates the translation effect, thereby enabling us to concentrate better on the hedging effect.
We first find optimal contracts from the firm’s point of view, in the first-best case of symmetric information, in a setting in which either the total volatility can be controlled cost-free, or the specific and the systematic risk may be controlled separately and cost-free. This extends (for the CARA case and cost-free effort) results of Ou Yang (2003) and Cadenillas, Cvitanic and Zapatero (2007) (henceforth CCZ 2007), to the presence of compensation hedging.
A number of other papers in recent years have studied the effect of managerial hedging on incentives. We mention here the works of Jin (2002), Garvey and Milbourn (2003), Acharya and Bisin (2005), Bisin et al. (2006), Ozerturk (2006) and Gao (2008). Not unlike this paper, in those studies the firm and the manager have CARA preferences. However, unlike this article, most of those papers are set in a traditional principal/agent theory setting in which the agent controls only the return, and not the risk/volatility of the output, and consider only linear contracts. In such a framework, they focus on the dependence of the pay-per-performance sensitivity (PPS) on the underlying risks. We are, on the other hand, interested in how the possibility of hedging and the form of compensation contracts, possibly nonlinear, influence the manager’s choice of risk/volatility.
Optimal contracts may depend on the returns of the assets available for hedging, the type of compensation usually referred to as relative performance evaluation, or RPE. Moreover, in the first-best framework of observable managerial actions, and if the manager has either CARA preferences or devotes zero initial capital to hedging (say, using futures or swaps, as in Ozerturk 2006), we find that there is a contract which is optimal regardless of whether the manager can hedge or not, and which will, in fact, induce the manager not to hedge. This is accomplished even without monitoring the manager’s hedging activity, unlike in Bisin et al. (2006), where the manager does not hedge due to costly monitoring by the firm.
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