Policy Uncertainty, Corporate Risk-Taking, and CEO Incentives

Abstract

We show evidence that CEO risk-taking incentives represent a key mechanism through which policy uncertainty impacts the real economy. We document that high levels of policy uncertainty are associated with significantly lower future stock return volatility. This relation is stronger (more negative) for firms where the CEO has higher compensation delta or less transferable skills, and is weaker when the CEO has higher compensation vega. Furthermore, when policy uncertainty is high, firms are more likely to use financial hedging instruments and engage in more diversifying mergers, and CEOs sell more own-firm shares and exercise fewer options.

Keywords: Policy uncertainty, CEO compensation, Risk-taking, Return volatility, CEO delta, CEO vega, Hedging, Diversifying mergers

JEL Classification: G38, G18, G31, G32, G34, D81, J33, M12