Executive Compensation, Risk Taking and the State of the Economy
39 Pages Posted: 6 Dec 2010 Last revised: 1 Sep 2011
Date Written: August 2011
In this paper we present a model of executive compensation to analyze the link between incentive compensation and risk taking. Our model takes into account the loss in the value of an executive’s expected wealth from employment if the firm becomes insolvent during a bad state of the economy. We illustrate that a given compensation package may lead to different levels of asset risk under different economic states. Most importantly, we show that the positive relationship between equity-based compensation and risk taking may weaken and possibly disappear during systemic financial crises. An important policy implication from our analysis is that similar regulations may have different effects on risk taking depending on the state of the economy.
Keywords: executive compensation, risk taking, regulation, equity based compensation, economic crisis
JEL Classification: G12, G13, G21, G28, G38, E58
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