Executive Compensation, Hedging, and Firm Value

This paper examines the effects of hedging activities and executive compensation on firm value by incorporating the endogenous relationship between the two managerial decisions for a sample of U.S. oil and gas producers. Theories of hedging based on market imperfections imply that hedging should increase market value of firms. Likewise, the design of executive risk-incentive compensation is to align managerial interests with shareholders’ interests to maximize firm value. However, hedging may reduce the volatility of the firm’s cash flow, thereby reducing the value of executive risk-incentives compensation, and thus altering the managers’ incentives in firm-value maximization. As a result, it is of interest to investigate whether the original firm value maximization objectives embedded in respective corporate decisions on hedging and structuring of CEO compensation can be passed on when both managerial decisions are jointly determined. To investigate these issues, we collect detailed information on the extent of hedging, executive compensation and the valuation of oil and gas reserves. Since hedging reduces the firm’s stock price sensitivity to oil and gas prices, hedging policy may be affected by how managers are compensated. We show that hedging incentives and CEO’s risktaking incentives are significantly negatively correlated. To take into account the endogeneity between hedging and managerial risk-taking incentives, we use a simultaneous equations model to examine their impact on firm value. After controlling for firm characteristics and performance, we again find that hedging incentives and CEO’s risk-taking incentives are significantly negatively correlated with each other. Furthermore, we show that firm value is negatively affected by managerial hedging incentives and risk-taking incentives, and significantly affected by the extent of hedging. The finding provides further explanations to the results of Jin and Jorion (2006) in which hedging effect is negative but insignificant on firm value. * Corresponding author. Department of Finance, California State University, Northridge, CA 91330-8379, U.S.A., E-Mail address: [email protected], Tel: 818-677-4622, Fax: 818-677-6079.