CEO Compensation and Corporate Risk: Evidence from a Natural Experiment

Abstract:     
This paper examines the two-way relationship between managerial compensation and corporate risk by exploiting an unanticipated change in firms’ business risks. The natural experiment provides an opportunity to examine two classic questions related to incentives and risk — how boards adjust incentives in response to firms’ risk and how these incentives affect managers’ risk-taking. We find that, after left-tail risk increases, boards reduce managers’ exposure to stock price movements and that less convexity from options-based pay leads to greater risk-reducing activities. Specifically, managers with less convex incentives tend to cut leverage and R&D, stockpile cash, and engage in more diversifying acquisitions.

Number of Pages in PDF File: 56

Keywords: legal liability, regulatory risk, tail risk, stock options, compensation, managerial incentives

JEL Classification: J33, G32, G34, K13

working papers series