CEO Hedging Opportunities and the Weighting of Performance Measures in Compensation Contracts

This study examines the rather controversial practice of managerial hedging, which allows CEOs to delink their compensation from stock price performance. We presume that boards are aware of these practices and adjust the weights placed on accounting-based and stock-based performance measures in executive compensation contracts to mitigate the problem. Empirically, we find that, in the presence of managerial hedging opportunities, accounting-based performance measures receive more weight, whereas stock-based performance measures receive less weight in determining executive compensation. Moreover, these results are more pronounced when managerial hedging needs are high. Regarding the effects of earnings management resulting from accounting-based incentives, we find that good auditing and strong governance mechanisms strengthen the benefit of placing more weight on accounting-based performance measures. Taken together, our findings suggest that corporate boards shift the relative weights of performance measures in compensation contracts in response to managerial hedging opportunities, which is consistent with optimal contracting.