Abstract
This paper analyzes the incentive implications of executive hedge markets. The manager can promise the return from his shares to third parties in exchange for a fixed payment—swap contracts—and/or he can trade a customized financial security whose payoff is correlated with his firm-specific risk. The customized hedge security improves equilibrium effort incentives by diversifying—but not unwinding—the manager's firm-specific risk exposure. However, unless they are exclusive, swap contracts lead to a complete unraveling of incentives when the firm-specific risk, or the manager's risk aversion, is sufficiently high. When security customization is above a certain threshold, the manager only trades the customized security—he does not trade any non-exclusive swap contracts, and incentives improve. Accordingly, the concern that the manager's hedge market access will lead him to undo his performance incentives is valid only when the hedge market can provide low security customization, and it cannot enforce exclusivity in swap contracts. The emergence of hedge markets that can offer exclusive swap contracts and/or can provide high security customization increases managerial share ownership.
This is the pre-peer reviewed version of the following article, which has been published in final form at http://dx.doi.org/10.1111/j.1530-9134.2007.00141.x.