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

Charles A. Dice Center Working Paper No. 2017-20

Fisher College of Business Working Paper No. 2017-03-020

64 Pages Posted: 9 Oct 2017

See all articles by Karen H. Wruck

Karen H. Wruck

Ohio State University - Fisher College of Business, Department of Finance

YiLin Wu

National Taiwan University - Department of Economics

Date Written: October 5, 2017

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

Suggested Citation

Wruck, Karen H. and Wu, YiLin, Do CEOs Make Their Own Luck? Relative Versus Absolute Performance Evaluation and Firm Risk (October 5, 2017). Charles A. Dice Center Working Paper No. 2017-20; Fisher College of Business Working Paper No. 2017-03-020. Available at SSRN: https://ssrn.com/abstract=3048401 or http://dx.doi.org/10.2139/ssrn.3048401

Karen H. Wruck (Contact Author)

Ohio State University - Fisher College of Business, Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States
614-292-4330 (Phone)
614-292-2418 (Fax)

HOME PAGE: http://https://fisher.osu.edu/people/wruck.1

YiLin Wu

National Taiwan University - Department of Economics ( email )

21 Hsiu Chow Rd
Taipei, 10020
Taiwan

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