CEO hedging opportunities and the weighting of performance measures in compensation Shengmin Hung Hunghua Pan* Taychang Wang 12/06/2012 1

Outline  Introduction ‚ Hypotheses ƒ Data „ Empirical tests … Conclusions 2

Objective  When CEO can hedge easily, 3 the corporate board emphasize more on accounting-based performance measure than stock-based performance measure in compensation contract.

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) 4

 Bettis et al. (2012) find that most corporate boards do not ban insiders from using derivative instruments 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 cover their losses. 6

2. Hypotheses  Hypothesis1: Ceteris paribus, compensation is designed to emphasize accounting-based performance more than stock-based performance when managerial hedging cost is low. 7

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 8

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 volume of firm during the fiscal year. 9

 Mayhew and Mihov (2004)  the decision for firms to have option markets is determined by options exchanges, not by firms themselves. 10

2. Hypotheses  Not every manager wants to engage in hedging. Given no firm ownership or low firm-specific risk  Managers might have no incentive to hedge. Given large firm ownership or high firm-specific risk  Managers have more incentives to execute hedging transactions. 11

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). 12

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. 13

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. ƒ Construct nine groups from the interactions between the three firm-specific risk groups and three managerial ownership groups. 14

3. Data Sources  Database: ExecuComp, CRSP, Compustat, OptionMetrics  Sample period: fiscal year 1996 to  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 15

 Table 1 Descriptive statistics on sample firms Empirical tests

 Table 2 Pearson correlations between compensation and performance variables. 17

4. Empirical tests  Table 3 The effect of relative weight and managerial hedging cost on CEO compensation 18 H1

4. Empirical tests  Table 4 Stratified CEO ownership and the effect of relative weight and managerial hedging cost on CEO total compensation. 19 H2

4. Empirical tests  Table 5 Stratified CEO ownership and the effect of relative weight and managerial hedging cost on CEO cash compensation 20 H2

4. Empirical tests  Table 6 Stratified firm-specific risk and the effect of relative weight and managerial hedging cost on CEO total compensation. 21 H2

4. Empirical tests  Table 7 Stratified firm-specific risk and the effect of relative weight and managerial hedging cost on CEO cash compensation. 22 H2

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. 23 H2

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. ƒ Firm-specific risk encourages corporate boards to design compensation schemes that emphasize accounting-based performance. 24

Thank You 25