Production and hedging implications of executive compensation schemes

Sagi Akron; Simon Benninga

doi:10.1016/j.jcorpfin.2012.10.004

Production and hedging implications of executive compensation schemes

Sagi Akron, Simon Benninga

University of Haifa, Tel Aviv University

Research output: Contribution to journal › Article › peer-review

Abstract

This paper connects executive compensation with hedging and analyzes a crucial shareholders and managers agency source that evolves from the pricing of the hedging device. The shareholders are risk-neutral, while the risk-averse manager hedges the price risk of the manufactured quantity, and his compensation package includes equity-linked compensation-stock grants. Only when the hedging instrument's pricing includes a risk premium, hedging is costly to the shareholders, while it is costless to the manager. Then from the owners' point of view, we observe managerial over-hedging, increasing in the equity-linked compensation level. This result leads to a violation of the classical production and hedging separation theorem. We conclude that, in the case where the hedging device's pricing bears a risk premium, shareholders can regulate the corporate value diversion to managers through diminishing the managerial equity-linked compensation scheme or by putting restrictions on the extent of hedging activities of executives.

Original language	American English
Pages (from-to)	119-139
Number of pages	21
Journal	Journal of Corporate Finance
Volume	19
Issue number	1
DOIs	https://doi.org/10.1016/j.jcorpfin.2012.10.004
State	Published - Feb 2013

Keywords

Corporate hedging devices
Executive equity-linked compensation
Frictions
Optimal managerial compensation scheme
Regulation
Separation theorems

All Science Journal Classification (ASJC) codes

Business and International Management
Finance
Economics and Econometrics
Strategy and Management

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10.1016/j.jcorpfin.2012.10.004

Cite this

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title = "Production and hedging implications of executive compensation schemes",

abstract = "This paper connects executive compensation with hedging and analyzes a crucial shareholders and managers agency source that evolves from the pricing of the hedging device. The shareholders are risk-neutral, while the risk-averse manager hedges the price risk of the manufactured quantity, and his compensation package includes equity-linked compensation-stock grants. Only when the hedging instrument's pricing includes a risk premium, hedging is costly to the shareholders, while it is costless to the manager. Then from the owners' point of view, we observe managerial over-hedging, increasing in the equity-linked compensation level. This result leads to a violation of the classical production and hedging separation theorem. We conclude that, in the case where the hedging device's pricing bears a risk premium, shareholders can regulate the corporate value diversion to managers through diminishing the managerial equity-linked compensation scheme or by putting restrictions on the extent of hedging activities of executives.",

keywords = "Corporate hedging devices, Executive equity-linked compensation, Frictions, Optimal managerial compensation scheme, Regulation, Separation theorems",

author = "Sagi Akron and Simon Benninga",

note = "Funding Information: This research was supported by a grant to Akron from the Orgler Doctoral Fellowship Fund at the Faculty of Management of Tel Aviv University and by a grant to Benninga from the Israel Science Foundation and the Israel Institute of Business Research at the Faculty of Management of Tel Aviv University. We thank Axel Adam-M{\"u}ller, Gil Aharoni, Amitay Alter, Yaacov Amihud, S{\"o}hnke Bartram, Sasson Bar Yossef, Avraham Beja, Nahum Biger, Oded Braverman, Jonathan Carmel, David Disatnik, Eti Einhorn, Rafi Eldor, Dan Galai, Yehoshua Hoffer, Avner Kalay, Elli Kraizberg, Yoram Kroll, Abrahm Levi, Yaffa Machnes, Greg Pawlina, Zvi Safra, Yossi Spiegel, Dan Weiss, Zvi Wiener, Rafal Wojakowski, and Jumana Zahalka, for helpful comments and assistance. We also thank the participants of departmental seminars at Lancaster University, Tel Aviv University, Bar Ilan University, The Hebrew University, The Inter-Disciplinary Center Herzelia, The University of Haifa, and the MFA2011 session participants and its Corporate Finance Best Paper Award Committee.",

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PY - 2013/2

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N2 - This paper connects executive compensation with hedging and analyzes a crucial shareholders and managers agency source that evolves from the pricing of the hedging device. The shareholders are risk-neutral, while the risk-averse manager hedges the price risk of the manufactured quantity, and his compensation package includes equity-linked compensation-stock grants. Only when the hedging instrument's pricing includes a risk premium, hedging is costly to the shareholders, while it is costless to the manager. Then from the owners' point of view, we observe managerial over-hedging, increasing in the equity-linked compensation level. This result leads to a violation of the classical production and hedging separation theorem. We conclude that, in the case where the hedging device's pricing bears a risk premium, shareholders can regulate the corporate value diversion to managers through diminishing the managerial equity-linked compensation scheme or by putting restrictions on the extent of hedging activities of executives.

AB - This paper connects executive compensation with hedging and analyzes a crucial shareholders and managers agency source that evolves from the pricing of the hedging device. The shareholders are risk-neutral, while the risk-averse manager hedges the price risk of the manufactured quantity, and his compensation package includes equity-linked compensation-stock grants. Only when the hedging instrument's pricing includes a risk premium, hedging is costly to the shareholders, while it is costless to the manager. Then from the owners' point of view, we observe managerial over-hedging, increasing in the equity-linked compensation level. This result leads to a violation of the classical production and hedging separation theorem. We conclude that, in the case where the hedging device's pricing bears a risk premium, shareholders can regulate the corporate value diversion to managers through diminishing the managerial equity-linked compensation scheme or by putting restrictions on the extent of hedging activities of executives.

KW - Corporate hedging devices

KW - Executive equity-linked compensation

KW - Frictions

KW - Optimal managerial compensation scheme

KW - Regulation

KW - Separation theorems

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DO - 10.1016/j.jcorpfin.2012.10.004

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SN - 0929-1199

VL - 19

SP - 119

EP - 139

JO - Journal of Corporate Finance

JF - Journal of Corporate Finance

IS - 1

ER -

Production and hedging implications of executive compensation schemes

Abstract

Keywords

All Science Journal Classification (ASJC) codes

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