Too Much Pay Performance Sensitivity?

Abstract

We examine the relation between pay-performance sensitivity (PPS), the convexity of managerial compensation (Vega), and future stock risk and returns for a large sample of firms between 1992 and 2004. On average, both higher PPS and higher Vega are associated with lower future stock returns. Part of this negative relation may be due to a reduction in risk induced by risk-averse managers responding to increases in the sensitivity of their wealth to equity value. Confirming this effect, both total and idiosyncratic equity risks decrease following increases in CEOs’ PPS and Vega. However, even after correcting for lower future risk, future stock returns are negatively associated with the magnitude of option sensitivity. This finding is consistent with previous studies that link high option compensation to manager-owner agency problems. The results are robust to numerous specifications and controls.

Keywords: pay-performance sensitivity, stock returns, equity risk, agency problems

JEL Classification: G32, J33