Do CEOs Make Their Own Luck? Relative Versus Absolute Performance Evaluation and Firm Risk

Abstract

Influenced by their compensation plans, CEOs make their own luck through decisions that affect future firm risk. After adopting a relative performance evaluation (RPE) plan, total and idiosyncratic risk are higher, and the correlation between firm and industry performance is lower. The opposite is true for firms that adopt absolute performance evaluation (APE) plans. Plans including accounting-based performance metrics and/or cash payouts have weaker risk-related incentives. The higher idiosyncratic risk associated with RPE increases a firm’s exposure to downside stock return risk and lowers credit quality. Our findings are economically consistent with observed differences in firms’ financial and investment policies.

Keywords: CEO Compensation, Performance Measurement, Performance Metrics, Performance-Based Compensation, Relative Performance Evaluation; Absolute Performance Evaluation, CEO Incentives, CEO Stock Options, Governance, Risk, Systematic Risk, Idiosyncratic Risk, Industry Index Correlation, CEO Risk Taking, CEO

JEL Classification: D22, G12, G32, G34, J33, J41, O31