Risk Management Transparency and Compensation

We examine the optimal design of managerial compensation in a setting in which a manager must be induced to maximize shareholder value while managing the firm's cash flow risks. Our model shows that, while high-powered incentive pay (e.g., options) induces the manager to increase shareholder value, it also provides incentives to engage in unproductive risk-seeking activities. This trade-off suggests that transparent disclosures of risk management practices allow shareholders to provide more powerful incentives to the manager. We empirically test this prediction using a regulatory shock, namely, the issuance of Statement of Financial Accounting Standards No. 133 (FAS 133), which improves information disclosure of corporate use of derivatives. We find that FAS 133 enhances the awarding of convex compensation to financial officers who manage and oversee corporate derivative programs. The new standard, however, does not affect compensation for their peer executives (e.g., technical officers) who are unlikely to engage in the operation of derivatives program. Our findings support the optimal contracting hypothesis