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Managerial risk reduction, incentives and firm value.

Article Excerpt
Summary. Empirical evidence suggests that managers privately alter the risk in their compensation by trading in the financial markets. This paper analyzes the implications of the manager's hedging ability on her optimal compensation scheme, incentives and firm value. I allow the manager to reduce her systematic risk exposure by trading the market portfolio. I find that the manager's optimal hedge depends on the liquidity of the market. Due to imperfect liquidity, the manager's optimal hedge is not complete. The equilibrium pay-performance sensitivity and hence the manager's equilibrium incentives and the firm value increases in the liquidity of the market.

Keywords and Phrases: Pay-performance sensitivity, Hedging, Managerial compensation, Liquidity, Systematic risk.

JEL Classification Numbers: G30, G32.

1 Introduction

One central theme in the corporate finance literature is to align manager-shareholder interests by compensating the manager according to firm performance. The principal-agent model of executive compensation has illustrated a trade-off between providing incentives to the manager and optimal risk sharing. Tying the manager's compensation to firm performance increases the manager's incentives to maximize firm value. However, such schemes also expose the manager to some uncertainty over which she has no control. This theory produces the following empirical prediction: given the manager's effort aversion (i.e., the intensity of the moral hazard problem) and the manager's risk aversion (which determines the risk premium to be paid to the manager to bear risk), the compensation in riskier firms should be less sensitive to firm performance. (1)

An implicit assumption in the literature on risk and incentives is that it is prohibitively costly for managers to trade in the financial markets and privately alter their risk exposure. Restrictions that prevent the managers to trade in their own firms are commonplace. However, general transactions by managers in the stock market are not restricted. Recent evidence suggests that the managers do use the financial markets: An article in The Economist reports that the use of derivatives to hedge managerial exposure to firm risk has become a business of hundred millions of dollars. (2) By using such instruments or simply by trading in a market index, managers seem to be able to adjust the risk in their compensation.

This paper analyzes the implications of the manager's hedging ability on her optimal compensation scheme, her incentives and the firm value. To this end, I decompose the total risk into its systematic and firm-specific components. I allow the manager to trade in a market portfolio (but not in the stock of her own company) to alter the systematic risk exposure in her compensation. The manager trades as a rational but uninformed hedger in a Kyle type market setting. This market microstructure framework helps to endogenize the manager's diversification costs. In particular, it allows to relate the manager's hedging behavior and her equilibrium compensation scheme to the liquidity of the market where systematic risk is traded.

I show that due to imperfect liquidity, hedging the systematic risk is costly and the manager's optimal hedge is only partial: the manager does not diversify away all of the systematic risk in her compensation. The hedging demand is increasing in the liquidity of the market. The more systematic risk the manager hedges ex post, the more high-powered incentives she can be given ex ante. Accordingly, the optimal pay-performance sensitivity of the compensation scheme is increasing in the liquidity of the market. By combining elements of market microstructure theory and theory of managerial contracting, the paper builds a previously unexplored 'diversification link' between market liquidity, managerial incentives and the firm value. Equilibrium incentives and hence the firm value are increasing in the liquidity of the market portfolio (or the liquidity of the systematic risk security).

Three recent papers also address the managers' ability to hedge the systematic risk exposure in their compensation. A common theme in these papers is that the optimal compensation contract should take into account the manager's ability to diversify away the systematic risk (Garvey and Milbourn, 2003; Jin, 2002) or substitute between systematic and firm-specific risk factors (Acharya and Bisin, 2003). The innovation of this paper is to endogenize the manager's optimal hedge and derive a link between the market liquidity, incentives and the firm value.

In Jin (2002), hedging is costless, therefore the manager diversifies completely. However, Jin also acknowledges that, '..although in theory CEOs could fully adjust their market risk exposure through trading, in reality constraints might be placed on doing so.' Garvey and Milbourn (2003) introduce diversification costs by an exogenously specified cost function. They motivate this diversification cost by referring to short selling and wealth constraints for the manager. Their conclusion is that market (systematic) risk might be an important determinant of the pay-performance sensitivity for younger managers, since it is those managers who face higher diversification costs. This paper makes a complementary point by endogenizing the diversification cost and relating it to market liquidity. If the hedging instrument has lower liquidity, the manager can only partially diversify her systematic risk exposure. Therefore, the liquidity of the systematic risk security affects the equilibrium pay-performance sensitivity and incentives.

This paper contributes to the...

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