Common vs. Firm-Specific Risks in Relative Performance Evaluation

32 Pages Posted: 2 Jul 2013

See all articles by Martin G. H. Wu

Martin G. H. Wu

University of Illinois at Urbana-Champaign

Date Written: July 1, 2013

Abstract

This paper examines the trade-off between common and peers’ specific risks in relative performance evaluation (RPE). We establish that in order to remove common risk completely from management compensation contracts, it is sufficient and necessary that peers’ weighted specific risks are lower. Nonetheless, common risk needs not to be removed completely; the optimal use of RPE therefore entails a partial substitution of common for peers’ specific risks unless firms can hedge against peers’ specific risks. These results contribute to our understanding of factors affecting a firm’s peer choices and provide specific implications for the weak- vs. strong-form RPE tests.

Keywords: relative performance evaluation, the cost-benefit trade-off between common and firm-specific risks, the choice of peer firms, executive compensation

JEL Classification: J3, M2

Suggested Citation

Wu, Martin G. H., Common vs. Firm-Specific Risks in Relative Performance Evaluation (July 1, 2013). AAA 2014 Management Accounting Section (MAS) Meeting Paper, Available at SSRN: https://ssrn.com/abstract=2288042 or http://dx.doi.org/10.2139/ssrn.2288042

Martin G. H. Wu (Contact Author)

University of Illinois at Urbana-Champaign ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
(217) 333-5957 (Phone)
(217) 244-0902 (Fax)

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
242
Abstract Views
2,111
Rank
229,730
PlumX Metrics