Optimal Contracting with Unobservable Managerial Hedging

We develop a continuous-time model where a risk-neutral principal contracts with a CARA manager protected by limited liability to run a project. Its output can be increased by costly unobservable managerial effort, but it is liquidated if the manager quits. The manager can trade a market portfolio in an unobservable private account to hedge market risk in his compensation. New to the literature, our model setup permits compatibility of private saving and hedging, manager's risk aversion, and inefficient project liquidation in one contracting problem. Our optimal contract is a dynamic mixture of relative and absolute performance evaluations. This provides potentially a new explanation to the lack of relative performance evaluation in practice. Moreover, negative market shocks increase project liquidation probability, consistent with the heightened managerial turnover in bad market conditions. Finally, the optimal contract is implemented by risk management accounts, private debt and private equity in an entrepreneurship context