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Hedging by Executives: an Ethical Decision

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Submitted By nljennings
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Hedging by Executives: An Ethical Decision
Nicole Jennings
University of Maryland University College

Introduction
Hedging is a term used to describe the process of reducing risk exposure to a firm. Specifically, the use of derivatives, reduces this risk. A derivative is a tool whose value is based on something other than the market value of the firm (Ross, Westerfield, & Jaffe, 2013). Two of the most common derivatives are options and futures contracts. An option is a contract allowing the buyer to buy an asset on or before a certain date at a fixed price. A futures contract obligates the exchange to take place on a certain date for a specified price (Ross, Westerfield, & Jaffe, 2013). In today’s financial market, many executives of firms are given stock-based compensation. This serves as a positive reinforcement to the executive when the firm becomes more financially successful. It also serves as a negative reinforcement when the firm is doing poorly. While stock-based compensation may seem fairly logical, it results in an undiversified portfolio, which is not ideal as an investment because of unsystematic risk (Ross, Westerfield, & Jaffe, 2013). Hedging by executives has become a popular option for executives with stock-based compensation who want to reduce the risk of their portfolio (Dunham, Managerial Hedging and Firm Risk, 2010). The ethical dilemma of executive hedging has been a controversy in the corporate finance world for many decades. Some recent examples of executive hedging involve companies like Krispy Kreme, Hasbro, and Chattem. Dunham and Washer describe the major increase and decrease of stock prices for Switch and Data Facilities in 2008 (Dunham & Washer, The Ethics of Hedging by Executives, 2011). Unfortunately most shareholders in this case experienced a great financial loss. Hedging activities, however, prevented the CEO

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