CEO Compensation and Corporate Risk: Evidence from a Natural Experiment

57 Pages Posted: 2 Dec 2010 Last revised: 17 Jun 2014

Todd A. Gormley

Washington University in St. Louis

David A. Matsa

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER)

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School

Date Written: August 19, 2013

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 payoffs tend to cut leverage and R&D, stockpile cash, and engage in more diversifying acquisitions.

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

JEL Classification: J33, G32, G34, K13

Suggested Citation

Gormley, Todd A. and Matsa, David A. and Milbourn, Todd T., CEO Compensation and Corporate Risk: Evidence from a Natural Experiment (August 19, 2013). Journal of Accounting & Economics (JAE), 2013, 56(2-3), pp. 79-101.; AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1718125 or http://dx.doi.org/10.2139/ssrn.1718125

Todd A. Gormley

Washington University in St. Louis ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
(314) 935-7171 (Phone)

HOME PAGE: http://www.gormley.info

David A. Matsa (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States
847-491-8337 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School ( email )

1 Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6392 (Phone)
314-935-6359 (Fax)

HOME PAGE: http://www.olin.wustl.edu/faculty/milbourn/

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