Transcript CEO hedging opportunities and the weighting of performance

CEO hedging opportunities and the
weighting of performance measures in
compensation
Shengmin Hung
Hunghua Pan*
Taychang Wang
12/06/2012
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Outline

Introduction
 Hypotheses
 Data
 Empirical tests
 Conclusions
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Objective
 When
CEO can hedge easily,
the corporate board emphasize more on
accounting-based performance measure
than stock-based performance measure in
compensation contract.
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1. Introduction
 Managers
maximize shareholder profit only
when they cannot hedge to unwind their
incentives (Tirole, 2006).
 Investment banks and options markets provide
channels for managers to insulate against the
adverse effects of stock price movements.
 Bettis
et al. (2001)
 Jagolinzer et al. (2007)
 Bettis et al. (2012)
 Gao (2010)
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1. Introduction
 Bettis
et al. (2012) find that most corporate
boards do not ban insiders from using
derivative instruments.
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1. Introduction
 When
managerial hedging is easy and firms rely on
stock price information to reward managers
 Managers may have the incentive to invest in
projects that are too risky for shareholders.
 If these projects succeed
stock prices increase
 managerial compensation increase.
 If these projects fail
 stock prices decrease
 managers can use derivative instruments to
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cover their losses.
2. Hypotheses
 Hypothesis1:
Ceteris paribus, compensation
is designed to emphasize accounting-based
performance more than stock-based
performance when managerial hedging cost
is low.
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2. Hypotheses
 We
examine the effects of these interactions
on CEO compensation by using the following
equation:

Two measures of CEO compensation.
Cash pay
Total compensation
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2. Hypotheses

Measurement of variables
Measures of accounting and security price
performance
Accounting-based: ROA (Sloan, 1993)
Stock-based : Return
Measure of executive hedging cost (Gao, 2010)
Hedge(Dummy): is equal to 1 if the firm’s option
is traded in the six US option exchanges,
otherwise it is equal to zero.
Hedge(trading volume): is log value of the
average number of daily option trading volume9
of firm during the fiscal year.
Mayhew
and Mihov (2004)
the decision for firms to have option markets
is determined by options exchanges, not by
firms themselves.
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2. Hypotheses

Not every manager wants to engage in hedging.
 Given

Managers might have no incentive to hedge.
 Given

no firm ownership or low firm-specific risk
large firm ownership or high firm-specific risk
Managers have more incentives to execute hedging
transactions.
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2. Hypotheses
 We
focus on firm-specific risk, not systematic
risk, because systematic risk (the market
comovement) is outside managerial control.
 Firm-specific
risk is related to managerial
actions; that is, it is under managerial control
(Hölmstrom and Milgrom 1987).
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2. Hypotheses
 Hypothesis
2: Ceteris paribus, compensation
is designed to emphasize accounting-based
performance more than stock-based
performance when managerial hedging cost is
low and managerial hedging needs are high.
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2. Hypotheses
 Research
Designs

Sort our observations into three groups based
on the ownership of CEOs.
 Sort our observations into three based on the
firm-specific risk to control managerial hedging
needs.
 Construct nine groups from the interactions
between the three firm-specific risk groups and
three managerial ownership groups.
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3. Data Sources

Database: ExecuComp, CRSP, Compustat,
OptionMetrics
 Sample period: fiscal year 1996 to 2010.
 Remove financial firms and utility firms.
 Delete all the continuous variables at the 1% level
in both tails of the distribution.
 14,781 CEO total compensation-year observations
 15,081 CEO cash compensation-year observations
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4. Empirical tests

Table 1 Descriptive statistics on sample firms
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4. Empirical tests

Table 2 Pearson correlations between compensation
and performance variables.
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4. Empirical tests

H1
Table 3 The effect of relative weight and
managerial hedging cost on CEO compensation
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4. Empirical tests

Table 4 Stratified CEO ownership and the effect of
relative weight and managerial hedging cost on
CEO total compensation.
H2
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4. Empirical tests

Table 5 Stratified CEO ownership and the effect of
relative weight and managerial hedging cost on CEO
cash compensation
H2
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4. Empirical tests

Table 6 Stratified firm-specific risk and the effect of
relative weight and managerial hedging cost on CEO
total compensation.
H2
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4. Empirical tests

Table 7 Stratified firm-specific risk and the effect of
relative weight and managerial hedging cost on CEO
cash compensation.
H2
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4. Empirical tests

Table 8 Stratified both firm-specific risk and managerial
ownership and the effect of relative weight and
managerial hedging cost on CEO compensation.
H2
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5. Conclusion

Accounting information is useful in setting
managerial compensation when managers can
hedge to unwind their incentives.
 Managerial hedging needs affect the interaction
between managerial performance and hedging
cost.
 Firm-specific risk encourages corporate boards to
design compensation schemes that emphasize
accounting-based performance.
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Thank You
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