Are the Fama French Factors Treated as Risk? Evidence from CEO Compensation

Abstract

Asset pricing theory postulates that a risk factor correlates with individuals' marginal utility of consumption. Hence, under plausible preferences, individuals should become more risk tolerant given favorable factor returns. We show that this wealth effect predicts a positive association between performance pay in observed contracts and factor returns, and test this prediction empirically with commonly-used asset pricing factors, such as the Fama French and momentum factors. Over the period 1992-2014, our empirical results support the hypothesized relationship for the market, book-to-market and momentum factors. These relationships appear to be driven by the delta of options, and for the market factor, stock grants. We also find that factors constructed from bond prices are positively associated to incentives, incrementally to the Fama French factors, but obtain mixed evidence for higher-order market factors, liquidity factors or factors constructed from national income accounts, including pricing kernels.