Managerial hedging, equity ownership, and firm value

Finance

IFA Working Paper

Acharya V;Bisin A

2005

Risk-averse managers can hedge the aggregate component of their exposure to a firm's cash flow risk by trading in financial markets, but cannot hedge their firm-specific exposure. This gives them incentives to load their firm's cash flows on aggregate risk, that is, to pass up firm-specific projects in favor of standard projects that contain greater aggregate risk. Such risk substitution is a form of moral hazard and it gives rise to excessive aggregate risk in stock markets and excessive correlation of returns across firms and sectors, thereby reducing the risk-sharing among stock market investors. A contract specifiying managerial equity ownership of the firm can be desgined to mitigate this moral hazard. We show that the optimal contract might require "negative incentive compensation," whereby managerial ownership is smaller than in absence of this moral hazard. We characterize the resulting endogenous relationship between managerial ownership and (i) the extent of aggregate risk in the firm's cash flows, as well as (ii) firm value. We show that these endogenous relationships help explain the shape of the empirically documented relationship between ownership and firm performance.

This Working Paper replaces IFA 361.

Institute of Finance and Accounting

FIN 446

IFA Working Paper

No