CEO Compensation, Diversification and Incentives

83 Pages Posted: 10 Jan 2001

See all articles by Li Jin

Li Jin

Harvard Business School - Finance Unit

Multiple version iconThere are 2 versions of this paper

Date Written: December 2000

Abstract

This paper studies how firms tie CEO compensation to firms' stock market performance. I demonstrate that in theory and in practice there is a tradeoff between giving CEOs incentives and forcing them to hold an un-diversified position in the firm. Unlike the results of the existing literature, market risk is not necessarily a cost of providing incentives. The cost of giving incentives is the potential loss of diversification for the CEO. As a result, CEO incentive decreases with firm-specific risk, but may not decrease with market risk. This paper also incorporates the recent critique by Prendergast (2000), which argues that the relation between risk and incentive level is unreliably estimated when we fail to consider the effect of risk on the benefit of giving incentives. I study both sides of the incentive-diversification tradeoff simultaneously. I am able to show that after controlling for the other side of the tradeoff, higher incentive is observed when CEOs' efforts have higher productivity, or when firm has lower firm-specific risk level.

Keywords: Executive Compensation, Diversification, Firm-Specific Risk, Incentives, Pay-performance sensitivities

JEL Classification: J33, G30, G32, G34, G11

Suggested Citation

Jin, Li, CEO Compensation, Diversification and Incentives (December 2000). Available at SSRN: https://ssrn.com/abstract=254260 or http://dx.doi.org/10.2139/ssrn.254260

Li Jin (Contact Author)

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-5590 (Phone)
617-496-5271 (Fax)

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