Saltuk Ozerturk

Implications of Executive Hedge Markets for Firm Value Maximization

This paper analyzes the incentive implications of executive hedge markets. The manager can promise the return from his shares to third parties in exchange for a fixed payment—swap contracts—and/or he can trade a customized security correlated with his firm-specific risk. The customized security improves incentives by diversifying the managers firm-specific risk. However, unless they are exclusive, swap contracts lead to a complete unraveling of incentives. When security customization is sufficiently high, the manager only trades the customized security—but not any nonexclusive swap contracts, and incentives improve. Access to highly customized hedge securities and/or exclusive swap contracts increases the managers pay-performance sensitivity.

Hedge markets for executives and corporate agency

This paper analyzes the implications of executive hedge markets for firm value maximization in an optimal contracting framework. The main results are as follows: Without any hedging ability, the manager underinvests in risk at the firm level to diversify his own compensation risk. If the manager can trade a security correlated with firm specific risk, the underinvestment in risk is reduced, optimal managerial share ownership and equilibrium effort increase. If the manager can hedge by simulating the sale of his shares, however, he can completely undo any incentive scheme. The model predicts that a higher degree of financial market development implies higher managerial share ownership and more efficient risk taking at the firm level.

Acquisition of Information to Diversify Contractual Risk

Are hedging transactions that diversify a manager’s compensation risk detrimental to incentives, or can they improve contracting efficiency? If hedging provides efficiency benefits, should the manager or the firm undertake it? In our model, both the firm and the manager can trade financial portfolios to diversify the manager’s compensation risk. Prior to the portfolio selection, the parties need to acquire information on how different financial portfolios fit their diversification purposes. We illustrate that financial portfolios correlated with firm‐specific risk improve contracting efficiency. For equal information costs, it is optimal for the firm to undertake the hedging on the manager’s behalf.

Costly Managerial Hedging, Market Liquidity and Firm Value

Empirical evidence suggests that managers hedge the systematic risk in their compensation by trading in the financial markets. This paper analyzes the implications of the managers hedging ability on her optimal compensation scheme, incentives and firm value. We allow the manager to adjust her systematic risk exposure by trading the market portfolio. We find that; (i) the managers optimal hedge depends on the liquidity of the market. With imperfect liquidity, the managers optimal hedge is not complete and she bears some systematic risk. (ii) The equilibrium pay-performance sensitivity is decreasing in the market risk and increasing in the market liquidity. (iii) Since better hedging ability increases the managers equilibrium incentives, the firm value increases in the liquidity of the market where systematic risk is traded. This last result contrasts with previous studies that suggest a negative relationship between stock market liquidity and production efficiency.