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Managerial Hedging and Portfolio Monitoring

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Author Info
Alberto Bisin
Piero Gottardi
Adriano A. Rampini

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Abstract

Incentive compensation induces correlation between the portfolio of managers and the cash flow of the firms they manage. This correlation exposes managers to risk and hence gives them an incentive to hedge against the poor performance of their firms. We study the agency problem between shareholders and a manager when the manager can hedge his compensation using financial markets and shareholders can monitor the manager's portfolio in order to keep him from hedging, but monitoring is costly. We find that the optimal incentive compensation and governance provisions have the following properties: (i) the manager's portfolio is monitored only when the firm performs poorly, (ii) the manager's compensation is more sensitive to firm performance when the cost of monitoring is higher or when hedging markets are more developed, and (iii) conditional on the firm's performance, the manager's compensation is lower when his portfolio is monitored, even if no hedging is revealed by monitoring. Moreover, the model suggests that the optimal level of portfolio monitoring is higher for managers of firms whose performance can be hedged more easily, such as larger firms and firms in more developed financial markets. (JEL: G30, D82) (c) 2008 by the European Economic Association.

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Article provided by MIT Press in its journal Journal of the European Economic Association.

Volume (Year): 6 (2008)
Issue (Month): 1 (03)
Pages: 158-209
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Handle: RePEc:tpr:jeurec:v:6:y:2008:i:1:p:158-209

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Find related papers by JEL classification:
G30 - Financial Economics - - Corporate Finance and Governance - - - General
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information

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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Reich, S., 2007. "Robust Incentives," Cambridge Working Papers in Economics 0729, Faculty of Economics, University of Cambridge. [Downloadable!]
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