Corporate derivative use and the composition of CEO compensation

Global Finance Journal 21 (2010) 170–185

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Global Finance Journal j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / g f j

Corporate derivative use and the composition of CEO compensation Janikan Supanvanij a,⁎, Jack Strauss b a Department of Finance, Insurance and Real Estate, G.R. Herberger College of Business, St. Cloud State University, 720 4th Avenue South, St. Cloud, MN 56301, United States b Department of Economics, Saint Louis University, United States

a r t i c l e

i n f o

Article history: Received 4 April 2008 Accepted 15 May 2010 Available online 1 July 2010 JEL classification: G34 G38 Keywords: Compensation Hedging

a b s t r a c t This paper analyzes whether the composition of a CEO's compensation package and SFAS 133, a regulation designed to increase transparency of derivative reporting, affect a firm's use of interest rate and currency derivatives to hedge risk. Using a panel of S&P500 firms during 1994–2000, we demonstrate the importance of properly aligning CEO incentives with derivative use. Results demonstrate that hedging is positively related to long-term CEO compensation, and negatively related to short-term CEO compensation as well as exercisable options compensation. We also show that changes in derivative reporting influence the relationship between CEO compensation and derivative use. Our paper thus highlight that CEO incentives and derivative reporting transparency are a significant factor in determining a firm's hedging use. © 2010 Elsevier Inc. All rights reserved.

1. Introduction The relationship between the composition of CEO compensation and risk management is an important, but relatively unexplored area in finance. Prior studies report the relationship between longterm compensation and hedging, but none pays attention to short-term compensation. Firms hedge risk primarily to reduce the probability of financial distress by reducing the variance of a firm's cash flow (Berkman & Bradbury, 1996; Geczy, Mint" on, & Schrand, 1997; Smith & Stulz, 1985). Purchase of interest rate and currency derivatives also stabilize investment spending and can lead to lower tax payments by smoothing tax payments (Froot, Scharfstein, & Stein, 1993; Gay & Nam, 1998; Geczy et al., 1997). As a result, risk management strategies potentially increase firm value (Allayannis & Weston, 2001), and to the extent that CEO compensation is linked to firm performance, hedging of interest rate or currency ⁎ Corresponding author. E-mail address: [email protected] (J. Supanvanij). 1044-0283/$ – see front matter © 2010 Elsevier Inc. All rights reserved. doi:10.1016/j.gfj.2010.06.004

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movements should raise compensation. However, if CEO pays incentive packages are not correctly aligned with firm risk and performance in the short run and long run, agency problems likely exist, leading to suboptimal firm hedging strategies. We address the following two questions: does corporate interest rate and currency derivative use to hedge risk depend on the composition of CEO compensation? Does recent changes in regulations that increase transparency of derivative reporting, specifically SFAS 133, affect this relationship? The recent collapse of several high profile companies (e.g. Enron) highlights the misalignment of executive compensation and derivative use, and illuminates the importance of agency conflict and nontransparencies in damaging the financial health of a company. As a result of accounting and reporting problems in the 1980s and early 1990s, the Financial Accounting Standards Board (FASB) (1998) began to issue a number of standards on financial instruments. Until the issuance of SFAS 133, Accounting for Derivative Instruments and Hedging Activities, there was no effective accounting guidance for derivative financial instruments. SFAS 133 provides a comprehensive and consistent standard for the recognition and measurement of derivatives use, and requires that US firms recognize all derivatives as either assets or liabilities in their statements of financial positions and measure those instruments at fair value. The effective date of SFAS 133 was postponed several times during 1998–2000. The early implementation was encouraged. Before its broad implementation in 1998, there was considerable leeway in reporting derivative use, leading to substantial differences in financial statements across firms. Firms could choose not to report, report when only favorable, or choose to report only particular derivative transactions. Our focus is on the transition period of SFAS133 on derivative use. Beginning in 1994, firms are required to report the notional value of derivatives (contract value), but not the fair or market value. After the effective date of SFAS133, firms are required to report the fair value, not the notional value; hence, during 1998–2000, firms still report the notional value, and for our data, most firms that use derivatives, also report the gain or loss from using derivatives. After 2000, comparisons between fair and contract value are difficult. In particular, we test whether hedging is influenced by CEO options vs. common shares, long-term (options plus common shares) vs. short-term compensation (salary plus bonus and other annual compensation) and in-the-money vs. out-of-the-money options payouts. We also are the first to investigate whether a change in transparency of financial reporting, specifically SFAS133, alters the CEO's hedging/compensation relation. Our panel of S&P500 firms from 1994 to 2000 is longer and larger than prior works, controls for endogeneity problems in executive compensation, and considers if agency conflict influences the relationship between CEO compensation and risk management. Fundamentally, firms face a difficult balancing act with respect to risk and the composition of executive compensation. They want to encourage risk-taking and entrepreneurial activities related directly to the firms activities by encouraging CEOs with options compensation; however, at the same time, firms wish to minimize risky interest rate and currency movements associated typically with borrowing and foreign operations. The first activities if successful increase future cash flow and current firm equity, while the second type of risk activities are more indirect and unrelated to core business activities of the firm. Short-term compensation such as salary discourages risk and does not properly align the firm's incentives with their CEO, but is preferred by risk adverse executives. Share compensation should align the incentives of the firm and CEO, but in many circumstances instead promotes risk-averse CEO behavior since they are unable to diversify way the risk associated with their wealth. This underinvestment problem is likely severe, since shareholder wealth depends on future growth opportunities (Bryan, Hwang, & Lilien, 2000; Guay, 1999). Compensation of options can promote more risky behavior, but in practice many times is ineffective since the options are in or at-the-money and instead promotes more conservative behavior. Hall (1998) shows that if the current practice of granting in-the-money options were replaced by out-of-the-money options equal to 1.5 times the current stock price, the pay for performance sensitivity would rise by 27%. Surprisingly, the academic literature largely ignores the differing effects of short-term vs. long-term CEO compensation on corporate risk management activities; whereas, many consulting firms advertise that they specialize in tailored designed different payout schemes to induce strategic CEO behavior through the design of long-term share compensation schemes. We show that increases in CEO compensation of common shares are associated with higher levels of firm hedging, while increases in options compensation lower use of interest rate and currency derivatives. Common shares reward risk adverse behavior of the firm and hence hedging, since CEO's are risk adverse when they have a large portion of their wealth tied to

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common shares ( Stulz, 1984); whereas, option's payouts reward CEOs to pursue risk-taking and volatility if they are out-of-the-money but encourage derivative use to hedge risk if they are in-the-money due to the convex payout of options schemes (Carpenter, 2000). Our results further reveal that derivative use benefits long-term performance such as firm price, but is negatively related to short-term performance measures such as cash flow and earnings, presumably due to high costs. This is consistent with our finding that shortterm compensation such as salary and bonus reduces hedging. Evidence thus suggests long-term compensation encourages CEOs to act in the shareholders' best interests (maximize firm price) and hedge. In contrast, CEO salary and options compensation may misalign the incentives of the CEO (e.g., encouraging them to pursue short-term cash flow objectives or higher risk), leading to agency conflict. Our work is also the first to empirically investigate whether corporate derivative use is affected by whether CEOs receive exercisable or nonexercisable options and movements in the strike price relative to the share price in the CEOs compensation. Firms typically report to the SEC sixty-day exercisable options and longer term nonexercisable options; nonexercisable options give CEOs more opportunity to gain from volatility than sixty-day exercisable options. Our results show that decreases in the value of exercisable options leads to more firm hedging, likely due to attempts by the firm to maintain/preserve the option's value; whereas, decreases in the value of nonexercisable options leads to less hedging, presumably since CEOs gain by increased volatility. We show further that the ratio of the strike price of the options contract in the CEO's compensation package is strongly related to the ratio of vega-to-delta, (v/δ). Knopf, Nam, and Thornton (2002) report that as “the sensitivity to stock and stock options to stock price increases (delta), firms hedge more. However, as the sensitivity of manager's stock option portfolios to stock return volatility increases (vega), firms tend to hedge less.” They attribute this relationship to agency conflict, since compensation potentially increases due to the convex payoff structure of options. Additionally, Rogers (2002) also finds a strong negative relationship between CEO risk-taking incentives (v/δ) and derivative holdings, and Rajgopal, and Shevlin (2002) show executive stock options risk incentives exhibits a negative relation with oil price hedging, implying risk increases with vega. Lastly, for firms that adopted SFAS 133, a positive relationship exists between CEO short and long-term compensation and hedging. Increased transparency of derivative reporting hence mitigates the agency conflict of exercisable options and shortterm compensation. At the same time however, the level of derivative use fell for reporting firms, likely due to the regulation's complexity and the wariness of firms during the transition. Studies prior to 1994 used survey data on derivatives, due to the lack of public information on hedging activities. Recent studies use data from SEC files, but their sample periods are limited to only 1–3 years. In this paper, we focus on firms that use currency and interest rate derivatives, and examine explicitly whether the increase in transparency of SFAS 133, which most firms adopted in 1998, have affected a firm's use of derivatives. Our 7-year derivatives data are obtained directly from the financial statements, thus the sample is free from the non-response bias that is typical of survey samples. The paper is organized as follow. Section 2 reviews the literature. Section 3 describes the data and model specification. Section 4 presents the results and Section 5 concludes. 2. Review of the literature 2.1. Hedging Literature shows that hedging increases firm value by alleviating the underinvestment problem associated with costly external financing (Gay & Nam, 1998; Geczy et al., 1997; Nance, Smith, & Smithson, 1993), by lowering the expected costs of financial distress (Haushalter, 2000; Mian, 1996; Stulz, 1996), or by reducing expected taxes (Mian, 1996; Smith & Stulz, 1985). Adam and Fernando (2006) examine the gold industry and find that derivative use has positive NPV and modestly increases shareholder value. Belghitar, Clark, and Judge (2008) use 1995 UK data and find that both foreign currency and interest rate hedging are significant explanatory variables for firm value creation. Borokhovich, Brunarski, Crutchley, and Simkins (2004) also examine the debt capacity effects of interest rate hedging in US firms and find a positive relationship between leverage and interest rate derivative use. Their finding supports the argument that firms which hedge bankruptcy risk increase leverage and use more interest tax shield from debt. Thus, in case of no agency conflict, theory predicts a positive relationship exists between hedging and compensation.

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Agency theory focuses on the private motives of managers who attempt to maximize their personal wealth through corporate risk management activities that conflict with the firm's best interests. In the presence of agency conflicts between managers and shareholders, risk management can lead to the improper resource allocation and the destruction of shareholder value. Managers may support negative NPV projects because they can enjoy some private benefits. Hedging decisions thus can be linked to the form of ownership they hold. Managers with more wealth invested in a firm's equity are predicted to have greater incentives to manage the firm's risks. Managers with more option-like features in their compensation plan will take higher risks and hedge less (Haushalter, 2000). Industry-level studies of gold mining (Tufano, 1996) and savings and loans (Schrand & Unal, 1998) show empirical relationship between the managerial compensation and the corporate hedging choices that support theory. On the other hand, in the oil and gas industry, Haushalter (2000) finds mixed support for theory linking corporate hedging to the managerial risk aversion. The results show that the extent of hedging is negatively related with both the number of options held per officer/director and the market value of insider ownership. 2.2. Background on accounting for derivatives The Securities and Exchange Commission and the Financial Accounting Standards Board (FASB) (1998) have long been concerned about corporate derivatives use and has issued several standards addressing the disclosure requirements on these risk management tools. The first accounting standard that directly related to forward contracts was SFAS 8, Accounting for the Translation of Foreign Currency Transactions and Foreign currency Financial Statements. This standard, issued in October 1975, was suspended in December 1981 by SFAS 52, Foreign Currency Translation. In August 1984, FASB issued SFAS 80, Accounting for Futures Contracts, to deal with other forms of financial instruments (i.e., exchange-traded futures). It required firms to recognize a change in market value of an open futures contract at gain or loss in the period that it occurs. This results in deferred gain or loss being reported as assets or liabilities. In March 1990, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard No. 105 (SFAS 105) requiring disclosure on US corporations' off-balance-sheet risk and financial instruments with concentration of credit risk. This standard applied primarily to swap contracts and requires only disclosure of contract amount, not fair value. SFAS 107, issued in December 1991, was concerned about favorable and unfavorable exposures. It required firms to disclose the fair value of financial instruments in the notes to their financial reports, not in the primary financial statements. Since derivatives are contingent assets or liabilities that should be reported in the financial statements, the FASB issued SFAS 119 in October 1994 requiring firms to disclose more detailed information on derivatives use (i.e., notional values, nature, and terms of derivatives contracts across categories). This statement was effective for the fiscal years ending after December 15, 1994. However, these standards failed to provide adequate information on fair value and market risk. Derivatives were referred to offbalance-sheet transaction, and were not reported in the financial statements. Moreover, disclosure about derivatives was not uniform. FASB based the accounting on the type of instrument, rather than the purpose of derivatives use. For example, the accounting for futures and forwards contracts are different, even when firms use them for the same purpose. SFAS 133, entitled “Accounting for Derivatives Instruments and Hedging Activities,” was issued in 1998. It established the uniformity of accounting and reporting standards for hedging activities and derivative instruments, and eliminated previous inconsistencies in generally accepted accounting principles (GAAP). SFAS 133 requires that every derivatives instrument be recorded at its fair value in the balance sheet as either an asset or liability. The FASB stated that fair value is the only relevant measure of derivatives and the most relevant measure for financial instruments. The regulation also requires that changes in the derivatives' fair value be recognized currently in earnings unless specific hedge accounting criteria are met and that a company must formally document, designate and assess the effectiveness of transactions that receive hedge accounting. To determine the derivative's hedge effectiveness, firms must state the purpose of using derivatives, test them, and report the results. Hedgers must select the methodology (i.e., dollaroffset method, relative-difference method, variability-reduction method, and regression analysis), choose the measurement period, and specify an appropriate test statistics to distinguish a highly effective hedge from the others. We consider the effect of the SFAS 133 in this study although the effective date was postponed to June 15, 2000 because, during that transition period, firms were not unsure about when the

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effective date would be. Firm behavior may be affected by this matter. The standard was postponed several times and two amendments occurred during 1998–2000. SFAS 137 amended the effective date by 1 year and SFAS 138 amended the standard. For our data, 74% of sample firms that use derivatives report gains or losses of their instruments in their financial statements in 1998. 3. Data and model specification We choose all firms with positive shareholder equity and complete financial data from the S&P500. We exclude financial firms because they perform different business activities and use derivatives more frequently for trading purposes or performing dealer activities. Utility firms are dropped from the sample since they are heavily regulated. We consider only firms with positive shareholders equity because a negative market-to-book equity ratio is not a meaningful indicator of a firm's growth opportunity. The sample consists of 198 firms for 1994–2000, including 138 firms that hedge and 60 firms that do not use derivatives for total 1386 observations. The sample starts in 1994 since this coincides with SFAS 119, which requires firms to disclose the notional values and purposes of derivatives holding in their financial statements. Prior to this period, detailed derivative use was unavailable. The data on derivatives are collected from the Annual Reports (Form 10-K) that firms filed for SEC. The sample firms that implement the SFAS 133 early disclose the following items in their annual reports: 1) the existence, nature, and term of outstanding derivatives instruments, 2) the face amount of the positions at the end of the fiscal year (the notional amount), 3) the value that a firm would be received or paid in order to liquidate its own position at the end of the fiscal year (the fair value), 4) credit risk associated with the positions, and 5) the purpose of outstanding derivatives use (trading or hedging). Compensation data are collected from the Proxy Statements (Form Def-14A). Firm characteristic data are obtained from COMPUSTAT. 3.1. Derivatives hedging and compensation proxies The dependent variables are the notional values of derivative (DRVN) contracts, which are defined as the contract amount of derivatives standardized by total sales. We use firm reporting of forwards, options, and currency swap as the measure of corporate derivative use to hedging to hedge their foreign exchange risk. Interest rate swaps as well as other more exotic derivatives, such as cross currency interest rate swaps, interest rate caps, floors, options, futures, forwards, swaption, corridor, and interest rate lock agreement, forward starting swaps and basis swaps are used as the measure of interest rate hedging. For the firms that reported derivatives use in term of foreign currencies, we used exchange rates at their fiscal year end to convert those foreign currencies to US dollars.1 CEO's compensation are measured by exercisable options (OPEXC), nonexercisable options (OPNEXC) and total outstanding common shares (SHAREC) owned by a CEO. Both stock options and shares are standardized by the number of shares outstanding. The short-term compensation (COMSTC) consists of salary, bonus and other annual compensation, standardized by sales. We also calculate the sensitivity of exercisable options to changes in the underlying stock prices (δ) and changes in the underlying standard deviation (v). We use various control variables in our tests: investment opportunity, financial distress, taxes, currency exposure, liquidity, size, and profitability. The theoretical reasons for their inclusion and their measurements follow the literature, and a more detailed description is given in Appendix A. 3.2. Model specification We employ an instrument variable (IV) approach to accommodate for endogeneity or simultaneity between the firm's decisions to hedge and compensate its CEO. Since similar unobservable risk factors jointly affect both variables. An OLS framework suffers from a simultaneous equation bias. To avoid this bias and correct for endogeneity problems, we employ a two stage IV approach and use firm characteristics 1 There are nineteen hedgers that also report the usage of commodity derivatives over the sample period. Thirteen firms have completed data on the notional value of the commodity contracts during 1994–2000. Others report the fair value of the financial instruments or have incomplete information. The 60 sample firms that are classified as non-hedgers in this study do not report the usage of commodity derivatives in their financial statements.

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as our instruments.2 To correct for possible heteroskedasticity, we use a White Heteroskedasticity Test procedure with cross-sectional weights. The estimated equations are as follows: Derivativesit = αi + b1 OptionsFit + b2 SharesFit + b3 S
T CompensationFit + b4 XP = SPit + b5 Zit + εit

ð1Þ

Derivativesit = αi + b1 OptionsFit + b2 SharesFit + b3 S
T CompensationFit + b4 v = δit + b5 Zit + εit ð2Þ

where XP/SP is the strike price relative to closing stock price and Zit comprises the list of the following control variables: investment, financial distress, taxes, currency exposure, dividend yield, quick ratio, profitability, and firm size. A fixed effect model is used to allow the intercept to differ between firms. Multicollinearity between XP/SP and v/δ implies that we test these variables separately; further, it also means that in some cases we test the compensation variables separately. To evaluate whether currency and interest rate derivative use changed after the issuing of SFAS 133, we include a dummy variable in the model. DUM = 1 from 1998–2000 if the firm reports gain or loss from using derivatives in their financial statements; otherwise, DUM = 0. Disclosing the fair value may affect the CEO's decision to hedge. If CEOs decrease the derivatives use in the post period, the dummy variable (DUM) will be less than zero, and vice versa. To test whether the CEO's hedging decisions change after the issuing of SFAS 133, we include a dummy for compensation variables. The estimated equation is: Derivativesit = αi + b1 OptionsFit + b2 SharesFit + b3 S
T CompensationFit + b4 Dumit *OptionsFit + b5 Dumit *SharesFit + b6 Dumit *S
T CompensationFit + b7 Zit + εit

ð3Þ

If the coefficients of the dummy variables are zero (b4, b5, b6 = 0), it implies that regulation has no effect on derivatives use. If the coefficients of dummy variables are statistically different from zero, it implies that regulation affect the firm's decision to use derivatives. 4. Empirical results Descriptive statistics are presented in Table 1. On average, firms make extensive use of both currency derivatives and interest rate derivatives, comprising 6.5% and 3.9% of sale respectively. For currency risk hedging, firms prefer using forwards and options to currency swaps. Geczy et al. (1997) also show that firms with currency exposure resulting from foreign operations or import competitions are likely to use only forward contracts, or combination with futures or options, rather than currency swaps. Forwards contracts and options contracts are relatively low-cost methods for matching the payoffs of frequent and uncertain transactions. For interest rate risk, firms prefer hedging with interest rate swaps to other risk management tools. 4.1. Effect of compensation on hedging The results of our panel regression explaining a firm's notional values of derivatives for 1994–2000 are presented in Table 2. We find strong evidence that CEO compensation substantially explains hedging by firms. Increases in share compensation are positively and significantly related to corporate derivatives use; in terms of dollars, a $1 increase in CEO equity compensation results in additional $1.26 in corporate risk activities. The elasticity is 1.42% and indicates an elastic and economically significant response by firms to changes in CEO share compensation. Additionally, the sign is consistent with theory: compensation of shares should promote risk adverse CEO behavior (as they have a large percentage of their salary involved and more tied to the firm's future). Both factors motivate hedging and risk management. Whereas, increases in options compensation is significantly related to less corporate risk management; the coefficient in column 2 of OPEXF is − 0.37 with a t statistic of − 2.2. In terms of magnitude and elasticity, the response is rather small; a dollar increase in options payment leads to a fall of 0.0035 dollars in hedging with an elasticity of less than 0.02%. Nonetheless, this small response is economically significant as CEO 2 We use the following instruments in the simultaneous model: financial distress, growth, tax, business risk, total risk, currency exposure, liquidity, profitability, size and time. The adjusted R2 exceeds 70%, indicating that our model possesses good instruments.

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Table 1 Descriptive statistics. This table presents descriptive statistics of dependent and independent variables. The independent variables are: LTDTA, the ratio of long-term debt to total assets; MKBK, market-to-book ratio; TAX, tax-loss dummy (dummy equals 1 if the firm reports tax loss carry forward and 0 otherwise); SIZE, natural logarithm of sales; TFSALES, the ratio of foreign sales to total sales; DIVY, dividend yield; QUICK, quick ratio; NITA, the ratio of net income to total assets; TENURE, dummy variable for tenure (dummy equals 1 if being a CEO for less than or equal to 1 year and 0 otherwise); V/δ, the ratio of vega-to-delta; XP/SP, the ratio of strike price to stock price; OPEXC, exercisable options held by a CEO; SHAREC, fraction of shares owned by a CEO; SALARYC, CEO salary; and BONUSC, CEO bonus. Options are standardized by number of shares outstanding. Short-term compensation is standardized by sales. The dependent variables are the notional value of derivatives standardized by total sales (DRVN). The data on derivatives are collected from Annual Report (Form 10-K) that firms filed for SEC. Compensation data are collected from Proxy Statement (Form Def-14A). Others are from COMPUSTAT. The sample consists of 198 firms for 1994–2000. DRVN Mean Median Std. dev.

Mean Median Std. dev.

Mean Median Std. dev.

LTDTA

MKBK

TAX

0.3236 0.1988 0.7264

4.3448 3.0445 15.5517

0.2077 0.0000 0.4058

SIZE

TFSALES

DIVY

QUICK

30.4441 8.6392 144.2660

0.2205 0.1879 0.2158

NITA

TENURE

0.1029 0.0262 0.3879

0.0680 0.0637 0.0661 XPTOT/SP

Mean Median Std. dev.

0.7594 0.8562 0.2305 SHAREC

Mean Median Std. dev. No. of firms

0.0105 0.0010 0.0358

0.1155 0.0000 0.3198 XPNEX/SP 0.8250 0.9248 0.2250 SALARYC 0.0050 0.0001 0.0263

0.0187 0.0164 0.0158 V/δ 0.1821 0.1960 0.0685 OPEXC 0.0028 0.0011 0.0049

0.0203 0.0076 0.0657 XP/SP 0.7422 0.8484 0.2857 OPNEXC 0.0019 0.0009 0.0030

BONUSC 0.0052 0.0001 0.0362

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compensation differs by many orders of magnitude across firms; e.g., if a firm increases options compensation from the third to the fifth decile, hedging decreases by 55%. The payout structure of option contracts to CEOs thus leads to agency conflict since it rewards more volatile payouts and less hedging. Short-term CEO compensation either in the form of salary and bonus is also significantly linked to less corporate risk management; results in column 3 indicate that a dollar more of salary or bonus reduces hedging by −1.57 and −0.20, respectively. Results hence show that both shares and options compensation as well as cash vs. share compensation affect corporate risk management activities differently. To the extent that corporate risk management benefits the firm (see Review of the literature section and Table 4), long-run ownership incentives such as shares encourage them to act in shareholder's interests; however, when their wealth is not tied to ownership incentives, CEO behavior changes and suggests agency conflict. We next examine whether movements in the strike price of a CEO's exercisable options compensation relative to the firm's stock price affect hedging. If this variable is significant, and agency conflict exists as derivative use is determined by CEO incentives, not objectives relevant to the firm. The positive coefficient of XP/SP indicates that as the option's compensation package of management approaches out-of-themoney, firms increase derivative use. This is consistent with the interests of the CEO wishing to preserve is compensation package from being out-of-the-money. The potential large losses of an option from in-themoney to out-of-the-money is associated with more hedging by the firm, and benefits the CEO as corporate derivative use in this case preserves their exercisable options. Whereas, decreases in the XP/SP (strike-to-

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Table 2 Determinants of hedging. The variables are: LTDTA, the ratio of long-term debt to total assets; MKBK, market-to-book ratio; TAX, taxloss dummy (dummy equals 1 if the firm reports tax loss carry forward and 0 otherwise); SIZE, natural logarithm of sales; TFSALES, the ratio of foreign sales to total sales; DIVY, dividend yield; QUICK, quick ratio; NITA, the ratio of net income to total assets; TENURE, dummy variable for tenure (dummy equals 1 if being a CEO for less than or equal to 1 year and 0 otherwise); V/δ, the ratio of vega-todelta; XP/SP, the ratio of strike price to stock price; OPEXCF, the estimated number of exercisable options held by a CEO; SHARECF, the estimated fraction of shares owned by a CEO; SALARYCF, the estimated value of CEO salary; BONUSCF, the estimated value of CEO bonus; and COMSTCF, the estimated value of CEO short-term compensation (sum of salary, bonus and other annual compensation). Options are standardized by number of shares outstanding. The dependent variable is the notional value of derivatives contracts standardized by total sales (DRVN). The sample consists of 198 firms for 1994–2000.

LTDTA MKBK TAX SIZE TFSALES DIVY QUICK NITA

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

0.0001 0.0001 − 0.0005*** 0.0001 0.0038*** 0.0002 0.0003*** 0.0001 0.0066*** 0.0006 − 0.0244*** 0.0085 0.0073*** 0.0014 − 0.0896*** 0.0024

0.0007*** 0.0001 − 0.0005*** 0.0001 0.0047*** 0.0003 0.0005*** 0.0001 0.0076*** 0.0006 0.0074 0.0079 − 0.0082*** 0.0012 − 0.0645*** 0.0024 − 0.0004*** 0.0001 0.0072*** 0.0002

− 0.0035** 0.0014 − 0.0005*** 0.0002 − 0.0004 0.0004 0.0157*** 0.0006 − 0.0395*** 0.0012 − 0.1523*** 0.0213 0.5041*** 0.0216 − 0.1095*** 0.0036

0.1687*** 0.0025 − 0.0005*** 0.0001 − 0.0002*** 2.4E− 06 0.0003*** 4.6E− 06 − 0.1027*** 0.0019 − 0.2573*** 0.0114 0.2208*** 0.0033 − 0.0562*** 0.0025

0.0002*** 0.0001 − 0.0004*** 0.0001 0.0046*** 0.0001 0.0006*** 4.7E− 05 − 0.0048*** 0.0004 0.0165* 0.0089 0.0072*** 0.0016 − 0.1030*** 0.0026

− 0.0004*** 0.0001 − 0.0004*** 0.0001 0.0038*** 0.0002 0.0006*** 0.0001 − 0.0042*** 0.0005 0.0470*** 0.0110 0.0052*** 0.0019 − 0.0736*** 0.0023 − 0.0007*** 0.0001

0.0083*** 0.0002 − 0.0004*** 0.0001 0.0033*** 0.0002 − 0.0006*** 3.5E− 05 − 0.0032*** 0.0005 0.0033 0.0106 0.0094*** 0.0013 − 0.0850*** 0.0026 − 0.0008*** 0.0001

0.0089*** 0.0002 − 0.0004*** 0.0001 0.0054*** 0.0002 − 0.0004*** 3.0E− 05 − 0.0033*** 0.0005 − 0.0257** 0.0109 − 0.0153*** 0.0011 − 0.0841*** 0.0026 − 0.0008*** 0.0001

− 0.0652*** 0.0023

− 0.0204*** 0.0021

TENURE XP/SP

0.0077*** 0.0002

0.0072*** 0.0002

(V/δ)F − 0.3691** 0.1493

OPEXCF SHARECF SALARYCF BONUSCF COMSTCF

1.4333*** 0.0953

1.5429*** 0.0897 − 1.5746*** 0.0535 − 0.2034*** 0.0515

1.3474*** 0.0949 − 0.3789*** 0.0081 − 0.3666*** 0.0083

− 3.7108*** 0.0549

***, **, * indicate significance at the 1%, 5%, and 10% levels, respectively.

stock price of exercisable options) imply that the option is moving be in-the-money and the less likely hedging since in this case CEOs gain from higher volatility. The coefficient of XP/SP is very significant with a t statistic over 35; further, the variable is an economically important determinant of corporate risk management as a simple bivariate regression of DRVN on XP/SP yields an adjusted R2 of over 27%. For comparison, no control variable explains more than 18% of the variance. v/δ (vega divided by delta) is also an important determinant of hedging and a proxy for the relative riskiness of stocks vs. options. Columns 4–5 show that increase in v/δ lead to a decrease in hedging and confirm Rogers (2002); moreover, this variable is largely determined by XP/SP. A bivariate regression of v/δ on XP/SP yields a very significant negative relationship with a t statistic of negative fifty and an R2 of 0.55; additionally, the strong correlation implies that we avoid introducing both variables in the same regression to explain hedging due to multicollinearity. Results in columns 6–8 show that results for CEO compensation are robust to the exclusion of XP/SP or v/δ; increases in long-term (short-term) share price is related to more (less) hedging. Hence, results demonstrate that CEO risk-taking hence is significantly determined by whether their compensation is options or stock, as well as whether the options compensation is in-the-money.

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Table 3 Determinants of hedging: the effects of the strike price of exercisable and nonexercisable options. The variables are identical to Table 2 except here we also test for the effects of the average strike price of total options XPTOT (exercisable, XP and nonexercisable, XPNEX) relative to the stock price (SP). The variables in the table are: LTDTA, the ratio of long-term debt to total assets; MKBK, market-to-book ratio; TAX, tax-loss dummy (dummy equals 1 if the firm reports tax loss carry forward and 0 otherwise); SIZE, natural logarithm of sales; TFSALES, the ratio of foreign sales to total sales; DIVY, dividend yield; QUICK, quick ratio; NITA, the ratio of net income to total assets; TENURE, dummy variable for tenure (dummy equals 1 if being a CEO for less than or equal to 1 year and 0 otherwise); OPEXCF, the estimated number of exercisable options held by a CEO; OPNEXCF, the estimated number of nonexercisable options held by a CEO; OPTOTCF, the estimated number of total options held by a CEO; SHARECF, the estimated fraction of shares owned by a CEO; SALARYCF, the estimated value of CEO salary; BONUSCF, the estimated value of CEO bonus; and COMSTCF, the estimated value of CEO short-term compensation. Options are standardized by number of shares outstanding. The dependent variable is the notional value of derivatives contracts standardized by total sales (DRVN). The sample consists of 198 firms for 1994–2000.

LTDTA MKBK TAX SIZE TFSALES DIVY QUICK NITA TENURE XPTOT/SP

(1)

(2)

(3)

(4)

(5)

(6)

(7)

0.0011*** 0.0001 − 0.0004*** 0.0001 0.0031*** 0.0001 0.0007*** 0.0001 − 0.0034*** 0.0006 0.1276*** 0.0178 − 0.0444*** 0.0009 − 0.1091*** 0.0015 − 0.0004*** 0.0001 − 0.0105*** 0.0002

0.0018*** 0.0001 − 0.0004*** 0.0001 0.0038*** 0.0001 0.0018*** 0.0001 − 0.0116*** 0.0006 0.1128*** 0.0160 − 0.0250*** 0.0027 − 0.1246*** 0.0016 − 0.0004*** 0.0001 − 0.0101*** 0.0002

0.0012*** 0.0001 − 0.0004* 0.0002 0.0056*** 0.0002 0.0015*** 0.0001 − 0.0078*** 0.0007 0.1308*** 0.0121 − 0.0145*** 0.0020 − 0.1125*** 0.0029 0.0001 0.0001

− 0.0017*** 0.0001 − 0.0004*** 0.0002 0.0019*** 0.0002 0.0002*** 3.1E− 05 − 0.0189*** 0.0007 0.1845*** 0.0079 0.0038* 0.0019 − 0.1112*** 0.0025 − 0.0002*** 0.0001 − 0.0108*** 0.0002

0.0095*** 0.0002 − 0.0004*** 0.0001 0.0025*** 0.0001 − 0.0015*** 4.6E− 05 − 0.0208*** 0.0005 0.1556*** 0.0093 − 0.0046*** 0.0010 − 0.1121*** 0.0024 − 0.0006*** 0.0001 − 0.0126*** 0.0002

0.0111*** 0.0002 − 0.0004*** 0.0001 0.0041*** 0.0001 − 0.0012*** 4.6E− 05 − 0.0184*** 0.0005 0.1056*** 0.0102 − 0.0340*** 0.0010 − 0.1136*** 0.0024 − 0.0004*** 0.0001 − 0.0124*** 0.0002

0.0007*** 0.0001 − 0.0004*** 0.0001 0.0032*** 0.0001 0.0004*** 0.0001 − 0.0138*** 0.0005 0.1678*** 0.0127 − 0.0164*** 0.0013 − 0.1148*** 0.0018 − 0.0005*** 0.0001 − 0.0111*** 0.0002

(XPTOT/SP)^2 − 0.0154*** 0.0003

XPNEX/SP (XPNEX/SP )^2 OPEXCF OPTOTCF OPNEXCF SHARECF

−5.3945*** 0.3150 − 1.4136*** 0.1314 − 1.5887*** 0.2737 2.6710*** 0.1609

SALARYCF BONUSCF COMSTCF

− 0.4536*** 0.0081 − 0.4741*** 0.0089 −0.0158*** 0.0026

***, **, * indicate significance at the 1%, 5%, and 10% levels, respectively.

In Table 3, we further examine the effects of the strike price of nonexercisable and total (exercisable plus nonexercisable) options relative to stock price on hedging. Nonexercisable options give CEO's more opportunity to gain from volatility than sixty-day exercisable options. The convex payment of options compensation on risk management also implies that compensation of nonexercisable options relative to stock price (XPNEX) may affect hedging differently than exercisable options — controlling for out-ofthe-money nonexercisable options should encourage risky behavior, and less hedging. Results in

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(8)

(9)

(10)

(11)

(12)

(13)

(14)

0.0015*** 0.0001 − 0.0004*** 0.0002 0.0025*** 0.0001 0.0010*** 0.0001 − 0.0080*** 0.0007 0.1801*** 0.0153 − 0.0452*** 0.0010 − 0.1257*** 0.0019 − 0.0001 0.0001

0.0027*** 0.0001 − 0.0004** 0.0002 0.0041*** 0.0001 0.0023*** 0.0001 − 0.0172*** 0.0006 0.1356*** 0.0153 − 0.0323*** 0.0010 − 0.1443*** 0.0019 − 0.0001 0.0001

0.0014*** 0.0001 − 0.0004** 0.0002 0.0049*** 0.0001 0.0017*** 0.0001 − 0.0055*** 0.0006 0.1471*** 0.0182 − 0.0158*** 0.0025 − 0.1205*** 0.0016 − 0.0001 0.0001

− 0.0011*** 0.0001 − 0.0004** 0.0002 0.0014*** 0.0002 0.0007*** 0.0001 − 0.0231*** 0.0007 0.2166*** 0.0118 − 0.0004 0.0020 − 0.1345 0.0028 − 0.0001 0.0001

0.0123*** 0.0001 − 0.0004** 0.0002 0.0015*** 0.0002 − 0.0014*** 5.0E− 05 − 0.0206*** 0.0006 0.1717*** 0.0120 0.0015 0.0017 − 0.1355*** 0.0023 − 9.5E− 06 0.0001

0.0130*** 0.0002 − 0.0004*** 0.0002 0.0033*** 0.0001 − 0.0011*** 0.0001 − 0.0204*** 0.0006 0.1222*** 0.0116 − 0.0365*** 0.0012 − 0.1314*** 0.0023 − 0.0001 0.0001

0.0012*** 0.0003 − 0.0004*** 0.0002 0.0025*** 0.0001 0.0007*** 0.0001 − 0.0182*** 0.0006 0.2116*** 0.0119 − 0.0183*** 0.0011 − 0.1309*** 0.0023 − 0.0002*** 0.0001

− 0.0117*** 0.0001

− 0.0111*** 0.0001

− 0.0121*** 0.0002

− 0.0130***

− 0.0121*** 0.0002

− 0.0121*** 0.0001

− 0.0115*** 0.0002 − 5.0859*** 0.2487 − 1.9715*** 0.1137 − 2.2033*** 0.2646 2.3229*** 0.1430 − 0.5699*** 0.0105 − 0.5389*** 0.0107 − 0.0201*** 0.0023

Columns 1 and 2 of Table 3 show that the more the CEO is compensated with total options (exercisable and nonexercisable) and nonexercisable options, the less the CEO hedges. Further, since this relationship may be nonlinear, we square the variable and show in column 2 that it is also significantly negatively related to hedging. Note, a square term in Table 2 was also very significant but not shown for conciseness. A key assumption in our conclusion of agency conflict follows the assumption that corporate risk management benefits the firm (see for instance Allayannis & Weston, 2001). Table 4 explores this issue

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Table 4 The effects of derivatives use on stock price, earnings, cash flow, and CEO compensation. The variables are: LTDTA, the ratio of longterm debt to total assets; MKBK, market-to-book ratio; TAX, tax-loss dummy (dummy equals 1 if the firm reports tax loss carry forward and 0 otherwise); SIZE, natural logarithm of sales; TFSALES, the ratio of foreign sales to total sales; TENURE, dummy variable for tenure (dummy equals 1 if being a CEO for less than or equal to 1 year and 0 otherwise); DRVNF, the estimated notional value of derivatives contracts standardized by total sales; PRICE, the closing stock price; EPS, earnings per share; CFPS, cash flow per share; NITA, the ratio of net income to total assets; OWNC, the natural logarithm of the dollar value of shares owned by a CEO; COMSTCF, the estimated value of CEO short-term compensation; and OWNCOMSTC, the ratio of the dollar value of shares owned by a CEO to sum of salary, bonus and other annual compensation. The sample consists of 198 firms for 1994–2000.

LTDTA MKBK TAX SIZE TFSALES TENURE DRVNF

PRICE/EPS

PRICE/CFPS

NITA

CFPS

OWNC

COMSTC

OWNCOMSTC

− 31.1910*** 0.4247 0.1604*** 0.0018 6.5299*** 0.1014 12.6427*** 0.0639 − 57.5498*** 0.6763 − 2.1012*** 0.0436 165.7289*** 1.5015

−5.9503*** 0.2604 0.0798*** 0.0081 1.0649*** 0.0574 3.2041*** 0.0576 − 11.5640*** 0.4227 0.9306*** 0.0290 38.9473*** 0.8890

0.1143*** 0.0083 − 0.0009*** 3.1E− 05 − 0.0288*** 0.0011 0.0041*** 0.0006 0.4709*** 0.0136 − 0.0022** 0.0008 − 1.1520*** 0.0309

3.3797*** 0.1670 − 0.0099*** 0.0006 − 0.4547*** 0.0344 1.4050*** 0.0175 7.2740*** 0.2710 − 0.1083*** 0.0160 − 14.9206*** 0.6097

− 0.6896*** 0.1242 0.0017** 0.0008 0.1550** 0.0512 1.6401*** 0.0398 0.0503 0.1974 − 0.3640*** 0.0302 0.7677*** 0.2554

5.4E− 06 1.4E− 05 − 2.8E− 07*** 5.0E− 08 7.4E− 06*** 2.1E− 06 − 0.0002*** 4.4E− 06 0.0002*** 1.6E− 05 − 0.0001*** 8.6E− 07 − 0.0004*** 2.9E− 05

− 4348.0420*** 1054.8590 17.8551*** 0.7047 640.1676*** 36.0646 227.1494*** 84.1373 − 1658.4760*** 178.4060 − 270.6335*** 13.3179 1358.1630*** 310.8094

***, **, * indicate significance at the 1%, 5%, and 10% levels, respectively.

more thoroughly for our data, and tests the effects of hedging on stock price, earnings and cash flow. Agency conflict exists when the motives of CEOs lead to actions counter to firm performance. We show that hedging benefits the firm in the long run, not in the short run, since it imposes costs (and hence lowers earnings and cash flow) in the short term. In columns 1 and 2, we examine factors that determine the priceearnings and price-cash flow ratio; we view stock price as a long-term proxy for firm performance, and earnings or cash flow as a good measure for short-term performance. A positive link exists between instrumented derivative use (DRVNF, obtained by a two stage least squares method to avoid endogeneity) and PRICE/EPS (stock price divided by earnings per share) and PRICE/CFPS (stock price divided by cash flow per share). Hence, hedging benefits the firm's long-term objective relative to short-term earnings or cash flow. In columns 3 and 4, we alter the specification and examine two short-term measures of firm performance, NITA (net income divided by total assets, or the return on assets) and CFPS (cash flow per share). Data indicate that hedging negatively impacts both measures of short-term firm performance. The likely explanation is hedging typically is not cheap and its costs lower cash flow; at the same time, it lowers the probability of financial distress, improving firm price. In columns 5–7, we are interested in directly examining the effects of hedging on long-term CEO compensation (measured by the dollar value of ownership of CEO compensation in column 5) and short-term CEO compensation (measured by COMSTC in column 6). Lastly, we examine the ratio of long-term to short-term compensation in column 7. Hedging is associated with more CEO equity compensation; whereas, it is negatively related to short-term cash compensation. Hence, if the CEO is compensated largely with short-term compensation, firms do not hedge, which is consistent with the interests of the CEO, and counterproductive to the long-term performance of the company. Agency conflict is supported.

4.2. Effect of SFAS133 Have the relationship between CEO compensation and hedging altered for firms that adopted SFAS133? To sharpen the focus and contrast the different compensation variables, Table 5 presents compensation variables as a percentage of total compensation. Note, earlier results in Tables 1–3 are also robust to this specification in terms of sign and inference. The coefficients of DUM ⁎ OPEXCOMF, DUM ⁎ OPNEXCOMF and

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Table 5 Determinants of hedging: the effects of the strike price of exercisable and nonexercisable options.

LTDTA MKBK TAX SIZE TFSALES DIVY QUICK NITA TENURE v/δ

(1)

(2)

(3)

(4)

(5)

(6)

(7)

0.0282*** 0.0015 − 0.0005*** 0.0002 − 0.0450*** 0.0015 0.0299*** 0.0010 − 0.1449*** 0.0056 6.2441*** 0.3500 0.8799*** 0.0464 − 0.2256*** 0.0074 − 0.0011*** 0.0001 0.0257*** 0.0011

0.0191*** 0.002 − 0.0005*** 0.0002 − 0.0134*** 0.0015 0.0100*** 0.0009 − 0.0068 0.0067 0.1702 0.4682 0.1760*** 0.0547 − 0.2003*** 0.0081 − 0.0007*** 0.0002 0.0334*** 0.0013

0.0274*** 0.0007 − 0.0004** 0.0002 0.0027*** 0.0002 0.0069*** 0.0005 − 0.0118*** 0.0007 − 1.3177*** 0.0357 − 0.1398*** 0.0097 − 0.0494*** 0.0023 − 0.0001 0.0001 − 0.0002 0.0006

0.0486*** 0.0009 − 0.0004** 0.0002 − 0.0081*** 0.0003 0.0168*** 0.0007 − 0.0227*** 0.0014 − 2.1893*** 0.0558 − 0.2709*** 0.0237 − 0.0630*** 0.0034 − 0.0001 0.0001 0.0202*** 0.001

0.0205*** 0.0017 − 0.0004** 0.0002 − 0.0021*** 0.0004 0.0070*** 0.0006 − 0.0062*** 0.0012 − 0.9975*** 0.0531 0.0517** 0.0238 − 0.1732*** 0.0057 0.0006*** 0.0001 0.0197*** 0.001

− 0.001 0.003 − 0.0004** 0.0002 − 0.0001 0.0003 0.0110*** 0.0007 − 0.1580*** 0.0088 0.7486*** 0.1532 0.0294 0.0225 − 0.0358*** 0.0038 − 0.0004*** 0.0001

0.0193*** 0.0960*** 0.0019 0.0055 − 0.0004** − 0.0006*** 0.0002 0.0002 − 0.0032*** − 0.0408*** 0.0004 0.0034 0.0104*** 0.0492*** 0.0007 0.0037 − 0.1119*** 0.7430*** 0.0065 0.0634 − 0.2029 − 13.6410*** 0.1397 1.1034 0.0822*** 0.1049*** 0.0202 0.0255 − 0.0578*** − 0.7859*** 0.0036 0.0559 − 0.0004*** − 0.0001 0.0001 0.0001

4.3807*** 0.3694

0.4714*** 0.0239 0.0144*** 0.0052

− 0.8703*** − 0.5507*** 0.0517 0.0368 − 0.2717*** 0.0326 0.00962* 0.0042 0.1728*** 0.0215 0.0192*** 0.0051

0.1838*** 0.0096 0.0960*** 0.0020

0.2668*** 0.0247 0.8230*** 0.0302 0.2151*** − 0.6490*** − 0.2732*** 0.0207 0.0474 0.0284 0.9234*** 0.0942*** 0.1006*** 0.0303 0.0044 0.0020

2.8960*** 0.2455 0.9675*** 0.0313 5.2417*** 0.4495 1.0629*** 0.0314

0.3015*** 0.6643*** 0.5880*** − 0.2921*** 0.1266*** 0.0096 0.0161 0.029 0.0479 0.0367 0.0406*** 0.0498*** 0.8750*** 0.0435*** 0.0494*** 0.0051 0.0036 0.0306 0.0058 0.0036 − 0.0562*** − 1.1043*** − 0.0784*** − 0.0593*** − 0.8839*** − 0.0567*** − 0.0628*** 0.0020 0.0385 0.0038 0.0018 0.0303 0.0044 0.0017

6.7180*** 0.5509 1.0108*** 0.0317 − 1.0245*** 0.0314

v/δ F − 0.0740*** 0.0137 0.0346*** 0.0044

OPEXCOMF DUM* OPEXCOMF OPNEXCOMF DUM* OPNEXCOMF OPTOTCOMF DUM* OPTOTCOMF SHARECOMF

0.4819*** 0.0257 0.0281*** 0.005

− 0.9143*** 0.0450 DUM* 0.0843*** SHARECOMF 0.0023 SALARYCOMF − 2.2422*** 0.1124 DUM* 0.2101*** SALARYCOMF 0.0132 BONUSCOMF 3.4154*** 0.1003 DUM* − 0.1127*** BONUSCOMF 0.0168 COMSTCOMF DUM* COMSTCOMF DUM

(8)

0.3416*** 0.0413 1.0541*** 0.0384 0.1318 0.0808 1.1288*** 0.0384 0.1185 0.1756 1.2353*** 0.0456 1.3921*** 0.0964 1.0797 0.0454

0.0045 0.0087 0.1237*** 0.0038

The variables are identical to Table 3 except here we measure all types of compensation as fractions of total compensation. ***, **, * indicate significance at the 1%, 5%, and 10% levels, respectively.

DUM ⁎ OPTOTCOMF are positive, indicating that for firms that adopted SFAS133, a positive relationship exists between hedging and exercisable, nonexercisable and total CEO options compensation as a percentage of total compensation. An increase in transparency hence mitigated the prior negative

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relationship and agency conflict of exercisable options. Although the magnitudes are small, the link between nonexercisable options and hedging also increased. The regulation also leads to positive benefits in terms of the link between CEO stock compensation and hedging. The coefficient of DUM ⁎ SHARECOMF is significantly positive for all specifications, indicating that firms that complied with the regulation increased the link between hedging and CEO share compensation. The magnitudes of the coefficient in this case are fairly large (though they do depend on inclusion of other variables), with an average elasticity over 1.5%. Firms that complied with SFAS133 thus strengthened the relationship between hedging and relative CEO stock compensation. A positive relationship also exists between hedging, and short-term composition (DUM ⁎ COMSTOMF). This again supports our contention that an increase in transparency improves firm performance by strengthening the relationship between CEO compensation and hedging. Lastly, the DUMit term is negative for all specifications, indicating that reporting firms lower their use of derivatives. The likely explanation is that the introduction of the regulation was complicated and may have lead firms to be more wary of using derivatives during the transition period, since hedging can be costly in the short term. 4.3. Control variables We next analyze the signs of our control variables in Tables 2, 3 and 5 to determine whether they are consistent with theory and the prior literature. More detailed descriptions of the theoretical literature and its prediction can be found in Appendix A. Results support the financial distress theory, with long-term debt (LTDA) positively significantly related to hedging in 25 of 30 regressions, respectively. Firms that borrow more long-term use hedging to limit borrowing risk and tax payments. In all 30 regressions, in the four tables, MKBK b 0; hence, there is significant negative relationship between derivative uses and marketto-book ratio, indicating that higher growth firms are less likely to hedge their foreign exchange and interest rate risk. This finding is consistent with Mian (1996) who finds that costs associated with financial reporting requirements inhibit firms from effectively hedging their growth option-related exposures. He notes that, overall, the reporting requirements for hedging interest rate exposures are less restrictive than those for hedging currency exposures. The predicted positive relationship between TAX and hedging (see Appendix A for details) receives weak support, since its sign is not robust to specification. Larger firms engage in hedging activity more extensively than smaller firms, as a significant positive relationship exists between size and hedging in 24 of 30 regressions. The relationship between size and hedging is consistent with recent studies (Geczy et al., 1997; Haushalter, 2000) that larger firms use more derivatives because they benefit from economies of scale in hedging costs, particularly in setting up a hedging program. The relationship between foreign sales and hedging is negative in 27 of 30 regressions. This result may be drawn by the effect of interest rate hedging. Note that foreign sales significantly increase with currency derivative use (results not shown), supporting that hedging can help reduce the effect of exchange rate movements on a firm's foreign operations. Dividend yield is positively related to derivatives use in most specifications. This finding supports Mian (1996) that hedging is positively related to dividend yield and dividend payout (the ratio of dividend to net income). We also find that profitability decreases with currency derivatives use. This result supports Froot et al. (1993) that the level of cash available for investment is negatively related to the level of derivative use because of the lower needs for external financing. Lastly, we find that CEO tenure is negatively related to derivative use in most specifications, indicating that new CEO is less likely to participate in hedging activity. This finding is not consistent with Tufano (1996) who finds that a firm's tenure of senior executives in gold mining industry decrease with hedging. 5. Conclusion The Securities and Exchange Commission and the Financial Accounting Standards Board (FASB) (1998) have long been concerned about firms' derivatives use and has issued several standards addressing the disclosure requirements on the risk management tools. This paper analyzes the hedging/compensation relationship of S&P500 firms during 1994–2000, and explicitly focuses on the transition period of derivative reporting from notional value to fair value. Using a panel of S&P500 firms during 1994–2000, we demonstrate that increases in CEO compensation is positively related increase in derivative use by firms;

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whereas, and CEO compensation in the form of options, salary and bonus is negatively related to hedging. These corporate risk management activities benefit the CEO. Compensation of shares aligns the interests of the CEO with the long-term interests of the firm and result in increased hedging; whereas, compensation of options rewards risk (and hence less hedging), benefiting the CEO. Short-term CEO compensation such as salary and bonus also is associated with a less hedging by the firm. Our results further show that hedging can be costly in the short-run (and lowers firm earnings and cash flow), but is associated with a higher stock price, presumably by lowering the risk of financial distress. As a result, compensation of options, salary and bonus lead to agency conflict, because they reward counterproductive CEO behavior, by discouraging hedging. We also show that managerial decisions to use derivatives significantly related to the strike price in the management's package. The convex nature of options implies that if the strike price is only marginally below the stock's closing price, management could potentially lose the entire sum if an adverse shock unexpectedly occurs and the stock price moves lower. In this case, management has a strong incentive to hedge interest rate and currency movements in an attempt to preserve the stock price; whereas, if the strike price is substantially below the stock price, management has the incentive to increase volatility (and hence not hedge) to exploit the large potential gains of options compensation. We show hedging decisions are substantially explained by the degree the CEO's options compensation is in-the-money or out-of-themoney, and imply that agency conflict is prevalent. Our work is also the first to empirically investigate whether firms that adopted SFAS133, a regulation governing increased transparency of derivative reporting, altered the relationship between CEO compensation and hedging. Results show that SFAS 133 significantly reinforces the positive relationship between hedging and both CEO share and nonexercisable options compensation. Further firms that complied with SFAS133 increased their compensation of exercisable options, and implies that an increase in transparency help reduce the prior agency conflict. Thus, we demonstrate that hedging is significantly determined by the composition of CEO compensation as well as recent changes in derivative reporting regulations. Appendix A. Variable inclusion a. Investment opportunity Low cash flows encourage a firm to bypass profitable investment opportunities or increase the use of expensive external financing, resulting in an underinvestment problem. Hedging can ensure that a firm has sufficient internal funds available to take advantage of attractive investment opportunities by reducing unnecessary fluctuations in either investment spending or external financing (Froot et al., 1993; Geczy et al., 1997; Gay & Nam, 1998). However, Mian (1996) finds an inverse relationship between a firm's investment opportunities and its derivatives use, which does not support the hypothesis. He notes that the absence of a positive relationship between hedging and growth can be explained by the constraints imposed by mandated reporting requirements. The growth opportunities can be measured by market-tobook ratio, the likelihood that a firm will have positive NPV projects. b. Financial distress Hedging can increase a firm's value by reducing the deadweight costs (probability of default) and increasing the debt capacity (Froot et al., 1993; Haushalter, 2000). It can reduce the probability and the expected cost of financial distress by reducing the variance of a firm's cash flows or earnings (Smith & Stulz, 1985; Geczy et al., 1997; Berkman & Bradbury, 1998). Stulz (1996) recommends that a firm's risk management policy should be made jointly with its financing policy because hedging can be viewed as a technique that allows managers to substitute debt for equity. For firms with little or no debt financing, hedging allows managers to substitute debt for equity. It can change firms' capital structure and ownership structure by allowing firms to increase leverage, buy back their shares, and increase management's percentage ownership. Mian (1996) finds that interest rate hedgers have higher leverage and longer debt maturities than currency hedgers. Financial distress is measured by long-term debt to total assets.

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c. Taxes Hedging can increase the present value of tax shields by smoothing out earnings, which leads to lower tax payments. It ensures that the largest possible proportion of income over a complete business cycle falls within the optimal range of tax rates. Thus, firms in a higher tax bracket are more likely to use derivatives to help reduce their tax burden. If firms do not hedge their cash flows, the utilization of tax shields may be postponed to a later date, which leads to a reduction in their present value. Therefore, hedging is predicted to be positively related to tax shields, such as tax loss carry forwards. However, recent studies do not provide evidence to support the tax hypothesis that hedging decisions are motivated by tax savings strategies (Mian, 1996; Tufano, 1996). The results of Mian (1996)show no relation between hedging and tax loss carry forwards. Berkman and Bradbury (1996) and Howton and Perfect (1998) suggest using a taxloss dummy equal to 1 if a firm reports tax losses and 0 otherwise. d. Currency exposure Since exchange rate movements can affect foreign sales, firms with higher sales in foreign currencies should have greater incentives to use derivatives to reduce foreign exchange risk. Allayannis and Weston (2001) find that firms with foreign sales benefit from hedging for both dollar appreciation and depreciation. Currency exposure or degree of international involvement is measured by total foreign sales to total sales. e. Liquidity Liquidity is measured by the dividend yield (the ratio of cash dividend per share to closing price) and the quick ratio (the ratio of current assets excluding inventory to current liabilities). Firms that pay higher dividends may have a lower incentive to hedge because of their greater liquidity position. Berkman and Bradbury (1996) and Howton and Perfect (1998) suggest using quick ratio as a proxy for the level of hedging substitutes. Firms with higher quick ratio may have lower needs to hedge because they are more flexible to meet their cash flow needs. The coefficients on these variables are expected to be negative. f. Size The effect of size on derivatives use is not quite clear. Since the bankruptcy cost is a motivation for hedging, theory linking risk management to financial distress costs predicts a negative correlation between firm size and hedging. However, recent studies show that larger firms use more derivatives because they benefit from economies of scale in hedging costs, particularly in setting up a hedging program (Geczy et al., 1997; Haushalter, 2000). Stulz (1996) notes that, in practice, larger firms use derivatives more than smaller firms, even though they have less cash flows volatility and are less restricted access to capital. In this study, size is measured by natural logarithm of total sales. g. Profitability Based on Pecking Order Theory, firms will prefer to finance with internal funds rather than debt. They prefer raising capital, first from retained earnings, second from debt, and third from issuing new equity (Myers and Majluf, 1984). Thus, level of cash available for investment is negatively related to the level of derivative use because of the lower needs for external financing (Froot et al., 1993). We use the ratio of net income to total assets to measure level of cash available. h. CEO tenure We include a dummy variable for tenure. Dummy equals 1 if an executive is being a CEO less than or equal to 1 year, and 0 otherwise. Tufano (1996) find that a firm's tenure of senior executives in gold mining industry is negatively related to hedging.

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