The effect of managerial compensation structure on derivatives decisions

Abstract

We examine the effect of managerial compensation structure on two questions concerning corporate use of derivatives: whether or not to use derivatives. and for firms that use derivatives the choice between derivatives with different payoff structures. With regard to the first question we find a negative relationship between hedging and cash compensation. but a positive relationship between hedging and the stock option grants. In our full sample we find no support for other hedging theories. Using a sub-sample of firms that only use linear derivatives we find that the compensation variables remain significant determinants of hedging: however. we also find support for the financial distress and underinvestment problem theories of hedging. With regard to the second question we find strong evidence that firms with managers whose compensation is weighted toward stock option grants tend to favor non-linear instruments.