An Empirical Analysis of the Role of Risk Aversion in Executive Compensation Contracts

Abstract

This paper empirically tests the principal-agent model prediction that the use of performance measures for incentive purposes is affected by the agent's risk aversion. We identify proxies for managerial risk aversion that can be measured using publicly available executive compensation data and find that the use of both accounting and market performance measures in executive compensation contracts decreases as the level of risk aversion increases. The contribution of this paper is twofold. First, we provide strong evidence of the relevance of incorporating risk aversion in executive compensation research. The results indicate that risk aversion has a significant effect on the use of performance measures, which suggests that future executive compensation research should therefore take the level of risk aversion into account. Second, the risk aversion proxies that we test are robust, simple, and can easily be measured using publicly available data. As a result, these proxies can be used in future accounting research other than in the executive compensation area, such as, research on earnings management, CEOs' financing and investment decisions, and voluntary disclosure issues.