Acquisition of information to diversify contractual risk

Abstract

Are hedging transactions that diversify a manager's compensation risk detrimental to incentives, or can they improve contracting efficiency? If hedging provides efficiency benefits, should the manager or the firm undertake it? In our model, both the firm and the manager can trade financial portfolios to diversify the manager's compensation risk. Prior to the portfolio selection, the parties need to acquire information on how different financial portfolios fit their diversification purposes. We illustrate that financial portfolios correlated with firm-specific risk improve contracting efficiency. For equal information costs, it is optimal for the firm to undertake the hedging on the manager's behalf. © (2012) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.