Corporate Risk: CEO Overconfidence and Incentive Compensation

Abstract

Purpose – The purpose of this study is to investigate the association between corporate risk and the interaction between CEO incentive compensation and CEO overconfidence. Design/methodology/approach – This empirical study performs random and fixed effects regression analysis. It uses option-implied measures of CEO overconfidence. Findings – The authors contribute to the existing literature by showing 1) that the positive association between high CEO incentive compensation and corporate risk only exists in the sphere of overconfident CEOs and 2) that the positive association between overconfident CEOs and corporate risk only exists in the sphere of high CEO incentive compensation. The authors show that the combination of high CEO incentive compensation and CEO overconfidence is associated with an increase in corporate risk of approximately 6% while the individual effects are for all practical purposes negligible. The results imply that only the combination of high CEO incentive compensation and CEO overconfidence is associated with a significantly elevated level of corporate risk. Research limitations/implications – The findings are based on S&P 1500 non-financial firms in the period 2007-2016. Practical implications - The findings have important implications in terms of CEO selection and compensation. Originality – This study provides empirical evidence on the importance of the dual presence of high CEO incentive compensation and CEO overconfidence for corporate risk. Previous literature has primarily investigated these phenomena in isolation.