CEO hedging opportunities and the weighting of performance measures

in compensation

Shengmin Hung

Hunghua Pan*

Taychang Wang

12/06/2012

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Outline

① Introduction

② Hypotheses

③ Data

④ Empirical tests

⑤ Conclusions

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Objective

When CEO can hedge easily,

the corporate board emphasize more on accounting-based performance measure than stock-based performance measure in compensation contract.

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1. Introduction

Managers maximize shareholder profit only when they cannot hedge to unwind their incentives (Tirole, 2006).

Investment banks and options markets provide channels for managers to insulate against the adverse effects of stock price movements.Bettis et al. (2001)Jagolinzer et al. (2007)Bettis et al. (2012)Gao (2010)

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Bettis et al. (2012) find that most corporate boards do not ban insiders from using derivative instruments.

1. Introduction

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1. Introduction When managerial hedging is easy and firms rely on

stock price information to reward managers Managers may have the incentive to invest in

projects that are too risky for shareholders. If these projects succeed

stock prices increase managerial compensation increase.

If these projects fail stock prices decrease managers can use derivative instruments to

cover their losses.

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2. Hypotheses

Hypothesis1: Ceteris paribus, compensation is designed to emphasize accounting-based performance more than stock-based performance when managerial hedging cost is low.

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2. HypothesesWe examine the effects of these interactions

on CEO compensation by using the following equation:

Two measures of CEO compensation.Cash payTotal compensation

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2. Hypotheses Measurement of variables

Measures of accounting and security price performanceAccounting-based: ROA (Sloan, 1993)Stock-based : Return

Measure of executive hedging cost (Gao, 2010)Hedge(Dummy): is equal to 1 if the firm’s option

is traded in the six US option exchanges, otherwise it is equal to zero.

Hedge(trading volume): is log value of the average number of daily option trading volume of firm during the fiscal year.

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Mayhew and Mihov (2004) the decision for firms to have option markets

is determined by options exchanges, not by firms themselves.

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2. Hypotheses

Not every manager wants to engage in hedging.

Given no firm ownership or low firm-specific risk Managers might have no incentive to hedge.

Given large firm ownership or high firm-specific risk Managers have more incentives to execute hedging

transactions.

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2. Hypotheses

We focus on firm-specific risk, not systematic risk, because systematic risk (the market comovement) is outside managerial control.

Firm-specific risk is related to managerial actions; that is, it is under managerial control (Hölmstrom and Milgrom 1987).

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2. HypothesesHypothesis 2: Ceteris paribus, compensation

is designed to emphasize accounting-based performance more than stock-based performance when managerial hedging cost is low and managerial hedging needs are high.

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2. Hypotheses

Research Designs① Sort our observations into three groups based

on the ownership of CEOs.

② Sort our observations into three based on the firm-specific risk to control managerial hedging needs.

③ Construct nine groups from the interactions between the three firm-specific risk groups and three managerial ownership groups.

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3. Data Sources Database: ExecuComp, CRSP, Compustat,

OptionMetrics Sample period: fiscal year 1996 to 2010. Remove financial firms and utility firms. Delete all the continuous variables at the 1% level

in both tails of the distribution. 14,781 CEO total compensation-year observations 15,081 CEO cash compensation-year observations

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Table 1 Descriptive statistics on sample firms

4. Empirical tests

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4. Empirical tests Table 2 Pearson correlations between compensation

and performance variables.

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4. Empirical tests Table 3 The effect of relative weight and

managerial hedging cost on CEO compensation H1

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4. Empirical tests Table 4 Stratified CEO ownership and the effect of

relative weight and managerial hedging cost on CEO total compensation. H2

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4. Empirical tests

Table 5 Stratified CEO ownership and the effect of relative weight and managerial hedging cost on CEO cash compensation

H2

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4. Empirical tests

Table 6 Stratified firm-specific risk and the effect of relative weight and managerial hedging cost on CEO total compensation. H2

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4. Empirical tests

Table 7 Stratified firm-specific risk and the effect of relative weight and managerial hedging cost on CEO cash compensation.

H2

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4. Empirical tests

Table 8 Stratified both firm-specific risk and managerial ownership and the effect of relative weight and managerial hedging cost on CEO compensation.

H2

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5. Conclusion

① Accounting information is useful in setting managerial compensation when managers can hedge to unwind their incentives.

② Managerial hedging needs affect the interaction between managerial performance and hedging cost.

③ Firm-specific risk encourages corporate boards to design compensation schemes that emphasize accounting-based performance.

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Thank You