Rocking the Boat: How Relative Performance Evaluation Affects Corporate Risk Taking

44 Pages Posted: 28 May 2020

See all articles by Truc (Peter) Do

Truc (Peter) Do

University of Queensland - Faculty of Business, Economics and Law

Huai Zhang

Nanyang Technological University (NTU)

Luo Zuo

Cornell University - Samuel Curtis Johnson Graduate School of Management

Date Written: May 26, 2020

Abstract

We argue that relative performance evaluation (RPE) contracts introduce a tournament among the focal firm and peer firms. We test whether a firm’s riskiness is altered by its CEO’s incentive to win the tournament. We find that a firm with an interim losing CEO takes more risk in the remainder of the tournament period than a firm with an interim winning CEO. This effect is stronger when the interim period is closer to the end of the evaluation period and when winning the competition is more important to the CEO. Further analysis of the Sharpe ratio reveals that the increased risk as a result of the tournament incentive reflects a poor risk-return trade-off, an unintended consequence of RPE. In summary, our results suggest that a firm’s risk is determined by the incentive of its management to outperform peer firms in an RPE contract.

Keywords: Relative performance evaluation, tournament incentives, risk taking

JEL Classification: G30, J33

Suggested Citation

Do, Truc (Peter) and Zhang, Huai and Zuo, Luo, Rocking the Boat: How Relative Performance Evaluation Affects Corporate Risk Taking (May 26, 2020). Available at SSRN: https://ssrn.com/abstract=3610499 or http://dx.doi.org/10.2139/ssrn.3610499

Truc (Peter) Do

University of Queensland - Faculty of Business, Economics and Law ( email )

4072 Brisbane, Queensland
Australia

Huai Zhang

Nanyang Technological University (NTU) ( email )

Nanyang Business School
50 Nanyang Ave.
Singapore, 639798
Singapore
+65-6790-4097 (Phone)

Luo Zuo (Contact Author)

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

349 Sage Hall
Ithaca, NY 14853
United States
607-255-4002 (Phone)

HOME PAGE: http://www.johnson.cornell.edu/faculty-research/faculty/lz352/

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