CEO Compensation, Diversification and Incentives
Posted: 27 Jun 2003
This paper examines the relation between Chief Executive Officers' (CEOs') incentive levels and their firms' risk characteristics. I show theoretically that, when CEOs cannot trade the market portfolio, optimal incentive level decreases with firm's nonsystematic risk but is ambiguously affected by firm's systematic risk; when CEOs can trade the market portfolio, optimal incentive level decreases with nonsystematic risk but is unaffected by systematic risk. Empirically I find support for these predictions. Furthermore, I find that incentives for CEOs likely facing binding short-selling constraints decrease with systematic as well as nonsystematic risk, as predicted by theory. Thus, compensation practice is consistent with predictions of theory.
Keywords: Executive Compensation, Diversification, Firm-Specific Risk, Incentives, Pay-Performance Sensitivities
JEL Classification: J33, G30, G32, G34, G11
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