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Beneficial Hedging of Managerial Compensation

Abstract: Why are managers permitted to hedge their compensation packages through trades in financial markets? According to standard models of performance pay, hedging destroys the incentives that these packages create. By contrast, we argue that hedging is beneficial, because it preserves retention incentives while reducing income risk. Without hedging opportunities, pay flexibility would be attained through renegotiation rather than performance pay. The model predicts that there will be more performance pay when hedging is cheaper and when managerial labor markets are thicker and are more volatile. Moreover, cheaper hedging reduces firms’ costly investments into reducing the portability of managers’ human capital.