The Effect of Risk on the CEO Market
Review of Financial Studies 24(8), 2822-2863, August 2011
44 Pages Posted: 31 Dec 2009 Last revised: 20 Dec 2013
Date Written: December 4, 2010
This paper presents a market equilibrium model of CEO assignment, pay and incentives under risk aversion and heterogeneous moral hazard. Each of the three outcomes can be summarized by a single closed-form equation. In assignment models without moral hazard, allocation depends only on firm size and the equilibrium is efficient. Here, assignment is distorted by the agency problem as firms involving higher risk or disutility choose less talented CEOs. Such firms also pay higher salaries in the cross-section, but economy-wide increases in risk or the disutility of being a CEO (e.g. due to regulation) do not affect pay. The strength of incentives depends only on the disutility of effort and is independent of risk and risk aversion. If the CEO affects the volatility as well as mean of firm returns, incentives rise and are increasing in risk and risk aversion. We calibrate the efficiency losses from various forms of poor corporate governance, such as failures in monitoring and inefficiencies in CEO assignment.
Keywords: Executive compensation, incentives, talent, market equilibrium, risk, assignment
JEL Classification: D2, D3, G34, J3
Suggested Citation: Suggested Citation