Managerial hedging, equity ownership, and firm value

Acharya, V and Bisin, A (2005) Managerial hedging, equity ownership, and firm value. Working Paper. London Business School IFA Working Paper.

Abstract

Riskaverse managers can hedge the aggregate component of their exposure to a firm's cash flow risk by trading in ficial markets, but cannot hedge their firmspecific exposure. This gives them incentives to load their firm's cash flows on aggregate risk, that is, to pass up firmspecific 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 risksharing 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.