Incentive Compensation When Executives Can Hedge the Market: Evidence of Relative Performance Evaluation in the Cross Section


  • Gerald Garvey,

  • Todd Milbourn

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    • Garvey is at the Peter F. Drucker School of Management, Claremont Graduate University, and Milbourn is at the John M. Olin School of Business, Washington University in St. Louis. Thanks to Ming Dong, Art Durnev, Gerry Feltham, Bart Hamilton, Paul Oyer, Per Stromberg, Rick Green (the editor), an anonymous referee, and seminar participants at York University and the 2002 Colorado Summer Finance Conference for very helpful comments. We also wish to thank Xifeng Diao for excellent research assistance. Any errors are our own.


Little evidence exists that firms index executive compensation to remove the influence of marketwide factors. We argue that executives can, in principle, replicate such indexation in their private portfolios. In support, we find that market risk has little effect on the use of stock-based pay for the average executive. But executives' ability to “undo” excessive market risk can be hindered by wealth constraints and inalienability of human capital. We replicate the standard result that there is little relative performance evaluation (RPE) for the average executive, but find strong evidence of RPE for younger executives and executives with less financial wealth.