Time-Series Variation in the Efficacy of Executive Risk-Taking Incentives: Evidence From Macroeconomic Uncertainty

Abstract

Prior research establishes that boards of directors can encourage risk-averse managers to take risky actions by providing stock options and severance pay. We demonstrate that the ability of these incentives to encourage risk-taking hinges on the level of uncertainty facing the manager, and that the level of uncertainty varies across time. We confirm prior findings that stock option convexity encourages risk-taking, but find that this relation only holds when the level of uncertainty is low. We also confirm prior findings that severance pay encourages risk-taking, but find that this relation only holds when the level of uncertainty is high. Finally, we find that compensation committees respond to uncertainty by adjusting the level of option compensation. Overall, our results suggest that the effectiveness of incentives to take risk varies with the level of uncertainty facing the manager, and that boards consider this in annual compensation design.