Relative Performance Evaluation in Presence of Exposure Risk

47 Pages Posted: 18 Aug 2014 Last revised: 25 Aug 2016

See all articles by Robert F. Göx

Robert F. Göx

University of Zurich - Managerial Accounting; University of Zurich - Faculty of Economics, Business Administration and Information Technology

Date Written: October 1, 2014

Abstract

I study the consequences of a random exposure to common risk for the purpose of relative performance evaluation (RPE) and find that it significantly affects the usefulness and the empirical measurement of RPE. According to my analysis, the magnitude of the exposure risk not only determines how firms aggregate measures of common risk with measures of firm performance but also the extent to which the firms can control the impact of common risk on their own performance. Simulated regressions of my theoretical model indicate that a high exposure risk can prevent the correct identification of informative performance signals and cause a biased composition of customized peer groups. A high exposure risk also increases the likelihood of a type II error in implicit RPE tests. I evaluate two empirical strategies to control for the magnitude of the exposure risk and find that they significantly reduce the likelihood of a type II error.

Keywords: executive compensation, relative performance evaluation, reward for luck, exposure to common risk

JEL Classification: J33, M40, M46

Suggested Citation

Goex, Robert F., Relative Performance Evaluation in Presence of Exposure Risk (October 1, 2014). AAA 2015 Management Accounting Section (MAS) Meeting, Available at SSRN: https://ssrn.com/abstract=2478554 or http://dx.doi.org/10.2139/ssrn.2478554

Robert F. Goex (Contact Author)

University of Zurich - Managerial Accounting ( email )

Plattenstrasse 14
Zurich, CH-8032
Switzerland

University of Zurich - Faculty of Economics, Business Administration and Information Technology ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

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