Managerial risk reduction, incentives and firm value

Empirical evidence suggests that managers privately alter the risk in their compensation by trading in the financial markets. This paper analyzes the implications of the manager’s hedging ability on her optimal compensation scheme, incentives and firm value. I allow the manager to reduce her systematic risk exposure by trading the market portfolio. I find that the manager’s optimal hedge depends on the liquidity of the market. Due to imperfect liquidity, the manager’s optimal hedge is not complete. The equilibrium pay-performance sensitivity and hence the manager’s equilibrium incentives and the firm value increases in the liquidity of the market.