Managerial Incentives, Financial Innovation, and Risk-Management Policies

This paper studies the risk choices of a firm run by an effort and risk-averse manager, where the firm’s initial risk exposure is only observed by the manager. By eliminating zero NPV risk, hedging can improve the ability of firms to efficiently induce effort from their manager. We consider conditions under which information asymmetry about risk exposure alters the optimal compensation contract. In some settings, asymmetric information has no effect on the manager’s optimal compensation. However, in other settings, inducing the manager to hedge rather than speculate requires the optimal contract to directly account for hedgeable risk. When inducing the manager to hedge is sufficiently costly, the optimal contract may restrict the use of derivatives.