A Theory of Risk Management with Applications to Executive Compensation and Earnings Management∗

This paper presents a theory of risk management in which the choices of managers over effort and risk are imperfectly monitored by outsiders. In a principal-agent framework, hedging can reduce extraneous noise in the variables outsiders observe or create opportuni-ties for self-dealing behavior. The model reproduces several empirical features commonly described as anomalous, in an optimal-contract setting. In equilibrium, the hedged dis-tribution of output is hump-shaped and asymmetric: first, for outputs close to the mode of the distribution, managers are more likely to do well and less likely to do poorly; sec-ond, managers hedge against large gains and increase the likelihood of large losses. The model accounts for the prevalence of linear compensation schemes and the relatively low performance-pay coefficients observed in managerial jobs. A simple linear contract is op-timal over states with large payoffs or when the manager has access to all, or nearly all, fair hedges and gambles. In the latter case, the optimal contract may feature no observable performance-pay, yet elicit some effort. Empirical implications for the detection of earn-ings management, risk controls, robust contracting and observed compensation schemes across industries are also examined