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Published September 2014 | public
Journal Article

On managerial risk-taking incentives when compensation may be hedged against

Abstract

We consider a continuous time principal-agent model where the principal/firm compensates an agent/manager who controls the output's exposure to risk and its expected return. Both the firm and the manager have exponential utility and can trade in a frictionless market. When the firm observes the manager's choice of effort and volatility, there is an optimal contract that induces the manager to not hedge. In a two factor specification of the model where an index and a bond are traded, the optimal contract is linear in output and the log return of the index. We also consider a manager who receives exogenous share or option compensation and illustrate how risk taking depends on the relative size of the systematic and firm-specific risk premia of the output and index. Whilst in most cases, options induce greater risk taking than shares, we find that there are also situations under which the hedging manager may take less risk than the non-hedging manager.

Additional Information

© 2014 Springer-Verlag Berlin Heidelberg. Received: 1 August 2014; Accepted: 22 August 2014; Published online: 9 September 2014. J. Cvitanić, Research supported in part by NSF Grant DMS 10-08219. A. Lazrak, Research supported in part by the Social Sciences and Humanities Research Council (SSHRC) of Canada.

Additional details

Created:
August 22, 2023
Modified:
October 25, 2023