Noise Hedging and Executive Compensation

We address two apparent paradoxes of risk management: (1) managers hedge in order to avoid negative earnings surprises, yet they tend to hedge risks uninformative of the value of the company; and (2) the presence of options in managers’ compensation distorts their incentive to hedge, inducing them to expose the company to too much risk. Our model is based on informational asymmetry between insiders (managers) and outsiders (investors). Investors derive information about company value from net cash flows (earnings), but the information revealed through earnings depends on the risk management strategy pursued by managers. Fully revealing earnings information is in the investors’ interest, so they design a compensation package to induce managers to make the earnings fully informative. With appropriate assumptions, we show that managers will select the efficient hedge strategy if their compensation includes stock options. Our model also provides a rational explanation for the observed vigorous response of stock prices to modest earnings surprises. Results based upon the analysis of Compustat and Execucomp data provide empirical support for our model; other things equal, firms that offer their CEO’s proportionately higher options-related compensation exhibit stronger stock price responses to changes in earnings and tend to have higher Tobin’s q’s.