Time-Series Variation in the Efficacy of Executive Risk-Taking Incentives: The Role of Uncertainty
54 Pages Posted: 1 Dec 2020 Last revised: 2 Mar 2021
Date Written: March 1, 2021
Prior research establishes that boards of directors can encourage risk-averse managers to take risky actions by providing stock options and severance pay. We demonstrate that the ability of these incentives to encourage risk-taking hinges on the level of uncertainty facing the manager, and that the level of uncertainty varies across time. We confirm prior findings that stock option convexity encourages risk-taking, but find that this relation only holds when the level of uncertainty is low. We also confirm prior findings that severance pay encourages risk-taking, but find that this relation only holds when the level of uncertainty is high. Finally, we find that compensation committees respond to uncertainty by adjusting the level of option compensation. Overall, our results suggest that the effectiveness of incentives to take risk varies with the level of uncertainty facing the manager, and that boards consider this in annual compensation design.
Keywords: executive compensation, market uncertainty, corporate governance, executive risk-taking incentives
JEL Classification: G30, G34, K22, M40, M46
Suggested Citation: Suggested Citation