Relative Levels of CEO Inside Debt and the Impact of Hedging on Shareholder Value

Abstract

This study examines the question of whether poorly diversified CEOs with high levels of inside debt engage the firm in costly hedging activity to reduce personal risk exposure at the expense of shareholder wealth. This study utilizes multifactor asset pricing regressions on the returns from self-financing portfolios of hedging firms that are long firms with high levels of CEO inside debt and short those with low levels. When these returns are value-weighted there is no evidence of significant abnormal returns, suggesting in aggregate hedging activity is not carried out at shareholder expense. Using equally-weighted returns that emphasize the typical smaller firms, however, result in significant negative abnormal returns, suggesting these firms lack the managerial sophistication and economies of scale to hedge efficiently, but still engage in costly hedging activity to mitigate CEOs’ personal risks at the expense of shareholders. In all models, high CEO debt firms are less risky than their counterparts, mostly in terms of market, size, and profitability risks as evidenced with significant factor loadings.