Managerial compensation under privately-observed hedging and earnings management

•We study managerial compensation in a model where the hedging outcome of a project is privately observable by managers.•The manager's effort is hidden, and the final revenue can be misreported at a cost.•More hedging opportunities increase the optimal pay-for-performance in compensation.•The positive association between incentive pay and hedging is consistent with the existing empirical evidence.

This paper studies how private information in hedging outcomes affects the design of managerial compensation when hedging instruments serve as a double-edged sword in that they may be used for both corporate hedging and earnings management. On the one hand, financial vehicles can offer customized contracts that are closely tailored to manage specific risk and improve hedging efficiency. On the other hand, involvement in hedging may give rise to manipulation through misstatement of the value estimates. We show that the use of privately-observed hedging may actually require greater pay-for-performance in managerial compensation.