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

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