The Moderating Effect of Relative Performance Evaluation on the Risk Incentive Properties of Executives' Equity Portfolios

Abstract

We offer evidence that the use of Relative Performance Evaluation (RPE) in CEOs’ incentive contracts influences the effect of risk-taking incentives on both the magnitude and composition of firm risk. We find that when the incentive design lacks RPE features, the incentive portfolio vega motivates CEOs to increase total risk through the systematic component because it can be hedged. In contrast, when the incentive design includes RPE features, CEOs prefer idiosyncratic risk because RPE filters out the systematic component of firm performance. We also document that the use of RPE reinforces the incentive portfolio vega's effect on the total risk.

Keywords: Executive compensation, relative performance evaluation, risk incentives, systematic and idiosyncratic risk

JEL Classification: M20, M21, M40, M41, M52