Yesterday's Heroes: Compensation and Creative Risk-Taking
Dartmouth College - Tuck School of Business
Harrison G. Hong
Princeton University - Department of Economics; National Bureau of Economic Research (NBER)
Jose A. Scheinkman
Columbia University; Princeton University - Department of Economics; National Bureau of Economic Research (NBER)
NBER Working Paper No. w16176
We study the relationship between compensation and risk-taking among finance firms using a neglected insight from principal-agent contracting with hidden action and risk-averse agents. If the sensitivity of pay to stock price or slope does not vary with stock price volatility, then total compensation has to increase with firm risk to satisfy as agent's individual rationality constraint. Consistent with this hypothesis, we find a correlation between total executive compensation, controlling for firm size, and risk measures such as firm beta, return volatility, and exposure to the ABX sub-prime index. There is no relationship between insider ownership, a proxy for slope, and these measures. Compensation and firm risk are not related to governance variables. They increasewith institutional investor ownership, which suggests that heterogeneous investors incentivize firms to take varying levels of risks. Our results hold for non-finance firms and point to newprincipal-agent contracting empirics.
Number of Pages in PDF File: 41
Date posted: July 12, 2010
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