Tuesday, July 12, 2011

CEO Compensation and Corporate Risk-Taking: Evidence from a Natural Experiment

Our paper sheds new light on the theoretically ambiguous effect of stock options on managerial incentives for risk-taking by analyzing how equity-based incentives affect firms’ responses to an unanticipated and exogenous increase in risk. The particular risk we study is an increase in liability and regulatory risk arising from workers’ exposure to newly identified carcinogens. We find that compensation contracts with high sensitivity to stock prices, low sensitivity to volatility, and options that are deep in-the-money reduce managers’ risk-taking incentives after risk increases. While options increase compensation’s sensitivity to both stock prices and volatility, on net, they encourage risk taking in our setting. We find that variation in managerial stock and option holdings causes meaningful differences in corporate decisions. Our findings underline the importance of corporate boards structuring and maintaining compensation plans properly in order to achieve their desired corporate strategy.

Source: Social Science Resource Network [via Knowledge@Wharton]

Download pdf publication | Link to SSRN Abstract

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