CEO Age, Risk Incentives, and Hedging Strategy

• DOI: http://doi.org/10.1111/fima.12166
• Author: Alfonso Giudice,Håkan Jankensgård,Ettore Croci
• Date: 01 September 2017
• Published date: 01 September 2017

CEO Age, Risk Incentives, and Hedging

Strategy

Ettore Croci, Alfonso del Giudice, and H˚

akan Jankensg˚

ard∗

We test whether managerial preferences explain how firms hedge, using hand-collected data on

derivative portfolios in the oil and gas industry.How firms hedge involves choosing between linear

contracts and put options, and deciding whether to finance these hedging positions with cash on

hand or by selling call options. The likelihood of being a hedger increases with chief executive

officer (CEO) age, and near-retirement CEOs prefer linear hedging instruments. The predictions

of the managerial risk incentives theory of hedging strategy, according to which managers with

convex compensation schemes avoid hedging strategiesthat cap upside potential, f ind no support

in the data.

A large number of firms use f inancial derivatives to manage their risk profiles (Bodnar, Hayt,

and Marston, 1998). However, there is considerable variation in the type of hedging strategies that

firms use to achieve their desired risk profiles (Adam, 2009). The issue of how f irms hedge has

typically received much less attention in the academic literature than the corresponding question

of why firms hedge. According to Adam (2009), studying how firms hedge might indirectly help

us understand why they hedge. Hence, a detailed characterization of how firms hedge is likely to

hold important clues for understanding hedging behavior, but this information has largely been

ignored in empirical studies of the determinants of corporate hedging.

The sparse literature on how firms hedge reports two sets of findings. Adam (2009) investigates

the use of option-based hedging strategies in the gold mining industry and shows that the use

of options is systematically related to a firm’s financial status, consistent with the predictions of

the model in Adam (2002). Moschini and Lapan (1995), Brown and Toft (2002), and Gay, Nam,

and Turac (2003) emphasize that a strategy involving options may be optimal in the presence of

nonlinear risk exposures (e.g., due to production risk).

In this article, we extend this line of inquiry by analyzing whethermanagerial preferences affect

how firms hedge. Specifically, we empirically test how managerial preferences affect hedging

strategies using a sample of US oil and gas firms included in the S&P 1500 between 2000 and

2013. This industry is suitable for our purposes because it is comparatively homogenous yet

offers a substantial variation in hedge ratios (Jin and Jorion, 2006). In addition, this industry

is one of the very few in which sufficient data on derivative positions are available. Thanks to

The authors wish to thank an anonymous referee, Raghavendra Rau (Editor), Tom Aabo, Gustav Martinsson, Martin

Strieborny, Jens Forssbaeck, Ramin Baghai, Frederik Lundtofte, Daniel Metzger, Emanuele Bajo, Massimiliano Barbi,

Don Chance, Nihat Aktas, and seminar participants at Stockholm School of Economics; Knut Wicksell Centre for

Financial Studies, Lund University; and Hanken School of Economics, Helsinki. We also thank workshop participants

at the Financial Management Europemeeting in Maastricht 2014 and the European Financial Management Association

meeting in Rome 2014 for helpful comments and suggestions. Jankensg˚

ard gratefullyacknowledges the financial support

of the Jan Wallander and Tom Hedelius Foundation.

∗Ettore Croci is Associate Professorin the Department of Economics and Business Administration, Universit`

a Cattolica

del Sacro Cuorein Milan, Italy. Alfonso del Giudice is Associate Professor in the Department of Economics and Business

Administration, Universit`

a Cattolica del Sacro Cuore in Milan, Italy.H ˚

akan Jankensg˚

ard is Associate Professor in the

Department of Business Administration, Lund University in Lund, Sweden.

Financial Management •Fall 2017 •pages 687 – 716

688 Financial Management rFall 2017

the extensive disclosure of hedging strategies by oil and gas firms, we are able to hand-collect

detailed data from 10-Ks, allowing us to distinguish between different hedging strategies. We

follow the empirical methodology in Adam (2009) involving multinomial regressions, using a

rich set of governance and financial control variables.

We focus on managerial preferences because there is a clear agency dimension to the choice

of hedging strategy. Jin and Jorion (2006) argue that investors may invest in a security to gain

exposure to an underlying risk factor (e.g., a commodity price). The willingness to hold the

security may partly reflect an optimistic view on the future development of the risk factor in

question. Accordingly, investors appear to prefer hedging strategies that preserve the upside

potential. Linear contracts are the least preferred strategy for these investors because they cap

the upside potential, followed by a strategy of selling call options to finance the purchase of

insurance. Purchasing put options using cash on hand preserves the entire upside exposure to the

risk factor. Hence, risk-averse managers have incentives that are at odds with the investors’ goal

of upside preservation, exposing the investors to potential agency problems.Hence, in this article

we examine when firms choose between linear contracts and options, and how they choose to

finance these hedging positions, that is, with cash on hand or by selling call options (henceforth

referred to as “hedging strategy” or “hedging instrument choice”).

We capture managerial preferences through chief executive officer (CEO) age and the risk-

taking incentives provided by the CEO’s compensation contract. Previous research has shown

that CEO age is related to corporate policies and risk taking (Yim, 2013; Serfling, 2014; Jenter

and Lewellen, 2015). CEOs face varying degrees of career risk depending on age (Scharfstein

and Stein, 1990; Hirshleifer and Thakor, 1992; Holmstrom, 1999), and physiological as well as

psychological changes that occur with age can influence on the willingness to take risk (Hambrick

and Mason, 1984; Bertrand and Mullainathan, 2003). The power of compensation-based risk-

taking incentives to explain corporate risk taking has also attracted considerable attention in

the academic literature (Tufano, 1996; Knopf, Nam, and Thornton, 2002; Rajgopal and Shevlin,

2002; Coles, Daniel, and Naveen, 2006; Hayes, Lemmon, and Qiu, 2012; Gormley, Matsa, and

Milbourn, 2014; Bakke et al., 2016).

We first consider how CEO age relates to hedging preferences. Hedging exposure to risk is

likely to reduce the variability of the firm’s payoff distribution and to reduce financial distress

risk (e.g., Smith and Stulz, 1985). Assuming that financial distress creates a signal of low ability,

younger CEOs prefer to hedge more because they suffer the consequences of impaired reputation

over a longer career horizon. We refer to this as the career risk hypothesis.1We also consider a

competing hypothesis regarding the impact of CEO age on hedging preferences. According to

the quiet life hypothesis, older CEOs are more averse to financial distress risk because of the

stress such a situation entails (for arguments on the preference of older CEOs for the quiet life,

see Bertrand and Mullainathan, 2003; Yim, 2013). In addition, financial distress may involve

cutbacks that adversely affect an organization to which older versus younger CEOs tend to have

greater psychological commitment (Stevens, Beyer, and Trice, 1978). Recent research has also

shown that CEO retirement preferences can have a significant impact on corporate policies. For

example, Jenter and Lewellen (2015) find that having a CEO who is approaching retirement

age sharply increases the likelihood that the firm will be taken over. Because of accumulated

firm-specif ic wealth and legacy concerns, CEOs close to retirement may be comparatively more

risk averse and inclined to hedge. Although the career risk and quiet life hypotheses establish

1This conjecture is similar in spirit to the argument in Yim (2013) that younger CEOs can reap the benefits of the pay

increase that typically accompany acquisitions overa longer horizon. Consistent with our conjecture, Eckbo et al. (2014)

show that in present value terms, the loss induced by firm bankruptcy is substantially higher for younger CEOs.