Business Leaders - Academic Article - Interest rate hedging and executive compensation

To hedge or not to hedge? This is certainly a question that has come up at many board room meetings. Let’s say you decide to hedge. What quantity? What products should you use? What durations should you use?  Let’s say you run an airline, and can project with a reasonable degree of certainty how much fuel you will use in the next fiscal year. Assume that you cover your exposure to Jet-A fuel at $115 per barrel (bbl) for the next year. Sounds reasonable, especially if something flares up in the Middle East, sending prices into the stratosphere. Everything is going great, until you realize too late that the world economy is slumping,  oil prices are dropping, and you’re locked into buying your largest input, at $150/bbl, when the rest of your competitors who dared not to hedge are buying fuel on the cash market at a cost of $115/bbl.  Hedging, while on the surface sounds straight forward, is multi-faceted to say the least. Its role in your company can also take another dangerous turn, when managers who have performance based compensation choose to under or over hedge.

In the Journal of Financial and Quantitative Analysis, Chernenko and Faulkender delve deep into the motivation of hedging, companies that use interest rate products to hedge exposures, and whether there is correlation between companies that apply less than optimal hedges for their portfolios, and executive compensation. The paper specifically focuses on interest rate hedging, rather than commodity (e.g., fuel) hedging, because interest rate hedges are typically listed with interest expense, where as commodities (and commodity hedging) are typically lumped in with operating activities.

Often a large portion of CEO and CFO pay is given in both stock and stock options.  “Looking finally at the compensation variables, a 1% increase in shareholder value increases the CEO compensation by $583,510.”  (Chernenko and Faulkender) Now, we all know that CEOs strive to increase shareholder wealth, but now we must ask ourselves “To what extent are they willing to do it.?”  When does an interest rate hedge turn into speculation on interests rates? The baseline used to compare hedging activities versus speculation activities is the optimal hedge ratio. The study finds that as the CEO (and CFO) delta increases, the more likely the company is to deviate from its optimal hedge ratio. One way this can be accomplished is by using floating rate debt (such as debt that floats against the London Interbank Offered Rate – (LIBOR)). This is more prevalent in a steepening yield curve environment. For example, the 3 month LIBOR rate is 47 basis points (bps), whereas the 1 year LIBOR rate is 107 bps. By having a floating rate, a company can save 60 bps, but they run the risk of interest rates increasing. By not hedging, they are effectively betting that interest rates will stay at or below 107 bps.

While on the surface, the choice on whether or not to hedge seems clear cut. In real life however, it is often anything but. One thing we do know however, is that if can boost CEO compensation, there is a decent chance the company is speculating.

 Based on:

Chernenko, Sergey, and Michael Faulkender. "The Two Sides of Derivatives Usage: Hedging and Speculating with Interest Rate Swaps." Journal of Financial and Quantitative Analysis. 46.6 (2011): 1727-54. Print.