Corporate Hedging and the Design of Incentive-Compensation Contracts

We use the introduction of exchange-traded weather derivative contracts as a natural experiment to examine the relation between risk and incentives. Specifically, we examine how executives’ ability to hedge weather-related risk that was previously difficult and costly to manage influences the design of executives’ incentive-compensation contracts. We find that the CEOs of firms that are relatively more exposed to weather risk—and therefore stand to benefit the most from hedging this source of risk—receive less annual compensation and have fewer equity incentives following the introduction of weather derivatives. We attribute the former finding to a reduction in the risk premium that CEOs demand for exposure to firm risk. The latter finding suggests that uncertainty in firms’ operating environments and equity incentives are complements in our sample firms. Collectively, our results highlight how hedging corporate risk influences agency conflicts and the associated incentive mechanisms.