Rivals risk-taking incentives and firm corporate policy

Abstract

This study contributes to the literature on the sensitivity of executives' compensation to risk, or vega, by examining the impact of rivals’ compensation on the firm's vega and its associated risk-taking corporate policies. Using firms from Compustat, I find that the vega of executive compensation is significantly and positively influenced by two determinants: rivals’ vega and competition intensity. The vega explained by these two determinants leads to lower return idiosyncratic risk, relatively more investment in research and development (R&D), and less investment in capital expenditures than the components of vega that are orthogonal to these determinants. I show that the explained vega, along with R&D, increases cash holdings and reduces the extent of corporate diversification. To validate a causal effect of rivals' managerial risk-taking incentives on firm risk and investment, I exploit vega changes incited by the FAS 123 R accounting regulation in 2005 that mandated stock option expensing at fair values. The findings remain consistent with earlier tests.