Fair Value Gains and Losses in Derivatives and CEO Compensation

This study examines the sensitivity of CEO compensation to fair value gains and losses in derivatives for firms in the U.S. oil and gas industry. Our evidence indicates that firms use derivatives for both hedging and non-hedging purposes and that the derivative gains have a substantial impact on firms’ overall earnings. We find that CEOs are rewarded for hedge derivative gains, more so in firms facing high financial contracting costs. However, we find that non-hedge derivative gains are also rewarded. Furthermore, the CEO compensation is more sensitive to non-hedge derivative gains than it is to non-hedge derivative losses. This is surprising because non-hedge derivatives often relate to speculation or inefficient hedging. Overall, our results suggest that the board does not fully distinguish between the nature of derivative activities and rewards all gains in a similar fashion. The presence of accounting financial expert on the compensation committee, however, does improve efficient contracting.