Risk management transparency and compensation

We examine the optimal design of managerial compensation in a setting where a manager must be induced to maximize shareholder value while managing the firm's cash flow risks. Our model shows that, while high-powered incentive pay (e.g., options) induces the manager to increase shareholder value, it also provides incentives to engage in unproductive risk-seeking activities. The trade-off suggests that shareholders’ monitoring of risk management practices facilitates the awarding of high-powered managerial compensation. We empirically test this prediction using a regulatory shock, namely, the issuance of Statement of Financial Accounting Standards No. 133 (FAS 133). The new standard enhances the stringency of hedge accounting treatments, thereby improving shareholders’ monitoring of firms’ speculative use of derivatives. We find that FAS 133 enhances the awarding of convex compensation to financial officers who manage and oversee corporate derivative programs. However, the new standard does not affect compensation for their peer executives. Our findings support the optimal contracting hypothesis.