On managerial risk - taking incentives when compensation may be hedged against

We consider a continuous time principal-agent model where the agent (the manager) can choose the output’s exposure to risk and the output’s expected return of the principal (the firm). Both the firm and the manager have exponential utility and can trade in a frictionless market. When the firm observes the manager’s choice of effort and volatility, there is an optimal contract that induces the manager to not hedge. In a two factors specification of the model where an index and a bond are traded, the optimal contract is linear in output and the log return of the index. Moreover, the pay per performance sensitivity of the optimal contract increases with the firm’s specific risk premium. We also consider a context where managers receive an exogenous compensation (shares or options) and illustrate how risk taking depend on the relative size of the systematic and specific risk premia of the output and of the index. In most cases options induce higher risk taking than shares. There are cases in which the hedging manager may be take less risk than the non-hedging manager, specifically, when the output’s risk premium is low. ∗Caltech, Humanities and Social Sciences, M/C 228-77, 1200 E. California Blvd. Pasadena, CA 91125. E-mail: [email protected]. †University of Warwick, Department of statistics, Coventry, CV4 7AL, U.K., [email protected] ‡University of British Columbia, Sauder School of Business, 2053 Main Mall, Vancouver, BC V6T 1Z2, Canada, E-mail: [email protected].