CEO Compensation, Diversification and Incentives

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