Corporate Hedging and the Design of Incentive-Compensation Contracts

• Main Authors: ARMSTRONG, Chris, Sterling HUANG
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2016
• Subjects: executive compensation; contract design; equity incentives; risk-taking incentives; stock options; derivatives; hedging; natural experiment; Accounting; Finance and Financial Management
• Online Access: https://ink.library.smu.edu.sg/soa_research/1520; https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?article=2547&context=soa_research
• Institution: Singapore Management University

We use the introduction of exchange-traded weather derivative contracts as a natural experiment to examine the relation between risk and incentives. In particular, we examine how executives’ ability to hedge uncontrollable weather-related risk that was previously difficult and costly to manage influences the design of executives’ incentive-compensation contracts. We also examine the whether the ability to hedge this important source of uncontrollable risk affects executives’ subsequent risk-taking. We find that the CEOs of firms that are relatively more exposed to uncontrollable weather risk—and therefore stand to benefit the most from hedging this source of risk—receive less annual compensation and have fewer equity incentives following the introduction of weather derivatives. We attribute the decline in annual compensation to a reduction in the risk premium that CEOs demand for exposure to uncontrollable risk. We attribute the decline in equity incentives to stock price becoming a more precise measure of CEOs’ actions—and therefore a more informative performance measure—so that fewer shares of stock and stock options are required to provide the same total incentives.