The Effects of Idiosyncratic Risks Borne by Managers on the Design of CEO Compensation Contracts

Abstract

We use proportional measures of CEO salary, bonuses, and option grants to analyze whether the design of managerial compensation contracts reduces idiosyncratic risks faced by managers. We use pooled cross-sectional data for a sample of 13,026 observations from 1,804 firms over the thirteen years from 1992 through 2004. We employ Tobit models with firm and year-specific fixed-effects in our econometric specifications. We test five hypotheses about the how the design of the compensation contracts are related to factors affecting the personal risks faced by the CEO's. In support of most of our hypotheses, the portion of salary granted seems to serve to balance out risks in CEO equity compensation and stock holdings. In many cases the portion of bonus compensation seems to have similar relationship with the elements of CEO idiosyncratic risk, but it is generally less sensitive to these risks than is the portion of salary compensation. As expected, the total level of CEO pay is positively related with the portion of salary compensation, and negatively correlated with option grants. On the other hand, salary compensation is positively correlated with the level of managerial stockholdings, while option grants are negatively related to the value of the portfolio. The case where our results are most at odds with the hypothesis is the effect of equity volatility on the structure of CEO pay, where the standard deviation of daily stock returns are negatively correlated with the portion of salary, and positively related to option grants. In our most unique findings, the deltas of the managers' equity portfolios have a U-shaped relationship with the portion of salary and an inverted U-shaped relationship with option grants. Bonus compensation is positively correlated with the delta. It is clear the option grants are the variable that is most sensitive to variations in the managers' portfolio deltas.