The Other Side of the Tradeoff: The Impact of Risk on Executive Compensation

41 Pages Posted: 26 Jan 1998  

Rajesh K. Aggarwal

Northeastern University

Andrew A. Samwick

Dartmouth College - Department of Economics; National Bureau of Economic Research (NBER)

Multiple version iconThere are 3 versions of this paper

Date Written: June 1998

Abstract

The principal-agent model of executive compensation is of central importance to the modern theory of the firm and corporate governance, yet the existing empirical evidence supporting it is quite weak. The key cross-sectional prediction of the model is that the executive's pay-performance sensitivity is decreasing in the variance of the firm's performance. We demonstrate strong empirical confirmation of this prediction using a comprehensive sample of executives at large corporations. In general, the pay-performance sensitivity for executives at firms with the least volatile stock prices is an order of magnitude greater than the pay-performance sensitivity for executives at firms with the most volatile stock prices. This result holds for both chief executive officers and for other highly compensated executives. We show that estimates of the pay-performance sensitivity that do not explicitly account for the effect of the variance of firm performance are biased strongly toward zero. We also test for relative performance evaluation of executives against the performance of other firms. We find little support for the relative performance evaluation model. Our findings suggest that executive compensation contracts are optimal with respect to risk-sharing but do not incorporate the potential informational advantages of relative performance evaluation.

JEL Classification: G30, J33

Suggested Citation

Aggarwal, Rajesh K. and Samwick, Andrew A., The Other Side of the Tradeoff: The Impact of Risk on Executive Compensation (June 1998). Available at SSRN: https://ssrn.com/abstract=47263 or http://dx.doi.org/10.2139/ssrn.47263

Rajesh K. Aggarwal (Contact Author)

Northeastern University ( email )

413 Hayden Hall
360 Huntington Avenue
Boston, MA 02115
United States

Andrew A. Samwick

Dartmouth College - Department of Economics ( email )

Hanover, NH 03755
United States
603-646-2893 (Phone)
603-646-2122 (Fax)

HOME PAGE: http://www.dartmouth.edu/~samwick

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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