Does CEO hedging alter the incentive system?
Yes, of course. This fascinating study found that in the year after executives and directors had engaged in hedging, their company’s stock often dropped markedly and there was an increase in financial restatements and shareholder lawsuits.
Over the last decade there has been an increased emphasis on tying executive’s wealth to firm performance through the use of stock and stock option based compensation. Little known in the literature is the development of derivative instruments that investors, and in particular insiders and large blockholders, can use to hedge their equity positions in the firm. Because these instruments typically protect against downward movements in the firm’s stock price one potential issue with these securities is that they can significantly weaken the sensitivity of wealth to firm performance of top executive officers including the CEO. Another concern is that they provide a mechanism that insiders can use to trade on inside information prior to adverse corporate events without the level of transparency typically associated with open market sales. We leverage a novel data set of over 2,000 hedging transactions spanning 1996 through 2006 to investigate the use of derivative securities by insiders and the motivation they have for hedging. The derivative contracts used typically are zero cost collars, prepaid variable forwards, equity swaps and exchange funds. We find a growing use in these instruments over this time period and that a diverse group of insiders (i.e., CEOs, CFOs, board chairman, corporate directors and beneficial owners) hedge a significant fraction of their ownership (30% on average for certain types of hedges). We also find a significant reversal in stock price subsequent to two types of hedging instruments – zero cost collars and prepaid variable forwards – but do not find a reversal in performance for insider investments into an exchange fund. The fact that some of these transactions precede poor performance suggests that the use of some of these instruments is information driven but also indicates there is heterogeneity in the reasons insiders hedge and in the type of instruments they choose. Our research suggests that studying the use of hedging transactions by insiders provides insight into incentive contracts and the effect insider trading has on significantly altering these incentive contracts.
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