CEO Risk Aversion Research Articles

How Large Is the Pay Premium from Executive Incentive Compensation?

ABSTRACT We estimate the pay premium associated with CEO incentive compensation. Using explicit detailed U.S. CEO compensation contract data and simulation analysis, we find that CEOs with riskier pay packages receive a premium for pay at risk that represents 13.5 percent of total pay. The premium is positively correlated with proxies for CEO risk aversion, but implied risk aversion values suggest that the premium is economically smaller than suggested by prior studies. We perform our tests using a variety of proxies to measure the variance of pay and find consistent evidence of economically small pay risk premiums. These results are consistent with recent findings suggesting that risk may have a more limited influence over the level of pay than previously thought. Data Availability: Data are available from the public sources cited in the text. JEL Classifications: D81; G30; J33.

The generalist CEO pay premium and CEO risk aversion

AbstractWe investigate whether and how managerial risk aversion influences the structuring of the generalist pay premium. We use three candidate variables for managerial risk aversion: the CEO's equity portfolio vega, decision horizon, and wealth. We find that equity‐based pay differs between generalist CEOs (who have broader experience spanning several industries) and non‐generalist CEOs (who tend to have narrower, specialized industry‐specific experience) based on their risk appetite. Further, how the generalist pay premium is structured depends on the risk aversion measure. Because generalist CEOs tend to be better paid than their counterparts, understanding their risk aversion level will help companies improve the structure of these CEOs’ compensation packages, and ultimately those of all CEOs. When vega is the risk aversion measure, CEOs get compensated for bearing risk. However, generalist CEOs with high vegas suffer a “risk discount” in their compensation. These generalist CEOs are associated with lower cash, equity, and total pay. CEOs with longer decision horizons get more equity and less cash, but this structuring does not extend to the generalist CEOs. Finally, wealthier CEOs get more cash and total pay. However, generalist CEOs who are wealthier get less cash pay.

CEO's Childhood Experience of Natural Disaster and CSR Activities.

Interest in the drivers of firms' corporate social responsibility (CSR) is growing. However, little is known about the influence of a CEO's childhood experience of natural disasters on CSR. Using archival data, we explore this relationship by offering three mechanisms that may account for how the CEO's childhood experience of natural disaster is related to their CSR. More specifically, while prior research has established a positive relationship based on the post-traumatic growth theory, we show that the dual mechanisms of prosocial values and a CEO's risk aversion explain the positive relationship. We further find that the positive relationship is stronger (1) when CEOs have longer career horizons and (2) when community social capital is high. This study contributes to both research and managerial implications on the topics of CEO's childhood experience and CSR. In particular, this study advances the upper echelon theory by revealing that a CEO's childhood experience of natural disaster is a useful yet relatively underexplored variable that can help explain the substantial variations in firms' CSR. Moreover, we emphasize that a CEO's career horizons and level of community social capital are important variables that further amplify the effect of a CEO's childhood experience of natural disaster on the firm's CSR commitment.

Does CEO Risk-Aversion Affect Carbon Emission?

Does CEO Risk-Aversion Affect Carbon Emission?

CEO gender and risk aversion: Further evidence using the composition of firm’s cash

Recent studies suggest that the conventional measure of cash holdings used to capture managerial risk-aversion may be inadequate. Using a new measure of physical cash, which adequately captures managerial risk-aversion, we deduce that female CEOs exhibit risk-aversion not only by maintaining higher physical cash levels but also by adopting risk-reducing policies. These risk-averse policies may be detrimental for some shareholders (despite evidence that female executives reduce agency conflicts) and they may impact the demand for female CEOs in the CEO labor markets. Our results are robust and lend support to the contention that female risk-aversion exists even beyond the “glass-ceiling”.

Disciplining Entrenched Managers Through Corporate Governance Reform: Implications for Risk-Taking Behavior

Research Question/Issue: This paper examines how enhanced monitoring by corporate boards following the passage of the Sarbanes-Oxley Act of 2002 and concurrent reforms to stock exchange rules (SOX) mitigated risk-related agency conflicts prevalent in entrenched firms. Research Findings/Insights: Post SOX, entrenched firms increased risky and value-enhancing investments. These investments were financed by reductions in financial slack and dividend payouts, and by lower cost of debt. The specific mechanism driving the positive changes in corporate policies of entrenched firms is the SOX requirement of an independent compensation committee. Managers of entrenched firms previously non-compliant with this requirement are rewarded with more equity-based pay after SOX, which strengthened their incentives to pursue value-creating riskier investments. Only firms with low information asymmetry benefit from this requirement. Theoretical/Academic Implications: The paper provides evidence of a disciplining effect of the critically important governance legislation on firms with entrenched management. The findings suggest that, by imposing an additional layer of discipline on managers, SOX increased managers' willingness to take on riskier, but more value-enhancing projects that were previously stifled in entrenched firms. The paper underscores the roles of an independent compensation committee and information cost in alleviating managerial risk avoidance. Practitioner/Policy Implications: The paper has implications for the ongoing debate among policy-makers and legislators on the costs and benefits of SOX and for future governance reforms. Legal enforcement of stricter board requirements can realign investment policies with shareholders' interests even in the presence of value-reducing firm-specific arrangements that entrench managers. However, majority independent board and fully independent audit and compensation committees do not rein in CEO's risk aversion. It is a fully independent compensation committee that is instrumental in incentivizing CEOs to pursue risky projects that also add value. Firms and policy-makers need to be aware that the effectiveness of the independent compensation committee in designing optimal pay policies depends on the access to timely and accurate information. Other mechanisms need to be considered to enhance risk-taking in entrenched firms operating in high cost information environment.

Cash holdings and CEO risk incentive compensation: Effect of CEO risk aversion

Liu and Mauer (2011) document that firm cash holdings are positively related to the risk incentive component of CEO compensation and attribute this relation to bondholder-shareholder conflicts. We propose that the positive relationship could be due to a managerial risk aversion effect and find supporting evidence for this view. In our study, we focus on zero debt and negative net debt ratio firms in order to minimize the possibility that the risk incentive effect on cash is driven by bondholder-shareholder conflicts as suggested by Liu and Mauer (2011). We find that vega is positively related to cash holdings and that this relationship is enhanced for firms with greater managerial risk aversion. We conclude that managers appropriately respond to risk incentives by taking on riskier projects but increase cash holdings to reduce their undiversified risk to the firm as a consequence of greater risk incentive compensation.

CEO traders and corporate acquisitions

This paper investigates whether the personal trading decisions of CEOs are related to their corporate acquisition decisions. We find that the personal trading performance of CEOs across all stocks they trade is significantly and positively related to the short-term performance of their mergers, and that CEOs exhibiting greater turnover on their personal common equity portfolios undertake acquisitions more frequently. Hence, a CEO's risk aversion, confidence and capability are consistent across their personal and corporate investment decisions.

Research on Combination of Inventive Mechanisms for Marketization-recruited CEOs in State-Owned Enterprises

The reform of state-owned enterprises has entered into a critical and deep-water area. Exploratory research on incentive methods for CEOs who are recruited into state-owned enterprises through market needs theoretical guidance and support from the related theories of incentive scheme and mechanism. The extant literature studied the combination of incentive mechanisms for CEOs; however, substitution relationship and complementary relationship between different incentive mechanisms are under-researched. This study develops theoretical models to study the effectiveness and restrictiveness interacted between different incentive mechanisms. According to our findings, the short-term performance share incentive and the effectiveness of long-term stock ownership incentive has a negative correlation with CEO risk aversion, environmental uncertainty and stock market uncertainty; the short-term performance share incentive, the long-term stock ownership incentive and CEO control incentive are complementary. Increase of CEO delegation should be considered when principal increases the CEO short-term performance share and long-term stock ownership incentive. Along with the development of enterprise, the effectiveness of CEO material incentive decreases, and the material incentive barely substitute the immaterial incentive. Principal needs to pay more focus on CEO immaterial incentive. This study enriches the extant literature by contributing implications to combination of incentive mechanisms for marketization-recruited CEOs in state-owned enterprises.

Default Risk, Inside Debt and Debt Incentives

We study the relation between firms' default risk and CEOs' debt incentives. Traditional principal-agent theory suggests that agency costs of debt are primary determinants of the relation. Specifically, firms with higher default risk are likely to face higher agency costs of debt and hence should provide higher debt incentives. Yet other factors affecting risk-taking, such as CEO risk aversion or career concerns, may diminish the need for firms with higher default risk to provide debt incentives. Using a difference-in-differences approach, we find evidence that does not support the agency costs of debt hypothesis, but is consistent with the risk-taking hypothesis.

CEO risk preferences and dividend policy decisions

This study examines whether risk aversion-inducing CEO compensation motivates managers to pay more dividends regardless of investor preferences. Using inside debt (i.e., pensions and deferred compensation) and the sensitivity of CEO equity compensation to stock price changes (i.e., high CEO delta), as proxies of CEO risk aversion, we document that inside debt induces CEOs to pay dividends while convex CEO compensation decreases dividend payout.

Evidence on exercise pricing in CEO option grants in two countries

This paper examines the relationship between exercise prices, grant size and CEO risk aversion employing a data set of Australian option grants characterized by exercise prices that vary relative to the stock price. We argue that Australian exercise price and grant size decisions provide an appropriate framework for evaluating the consequences of the U.S. practice of granting at-the-money options. Using a 3SLS estimation, we find that exercise prices are positive in grant size when internalizing CEO risk aversion but less so for the U.S. relative to Australia. We find also that CEO risk aversion is negatively related to both exercise prices and grant size in Australia but negatively related only to exercise prices in the U.S. A positive relation found between CEO risk aversion and grant size in the U.S. implies that risk aversion is addressed with larger grant sizes to compensate for fixed exercise prices.

Managerial Incentives, Risk Aversion, and Debt

AbstractWe investigate the risk choices of risk-averse CEOs. Following recent theoretical work, we expect CEO risk aversion to be more pronounced in firms with high leverage or high default probability. We find that the CEOs of these firms reduce firm risk, even in the presence of strong risk-taking incentives. Our results are robust to controls for the sensitivity of CEO wealth to stock price changes, firm risk determinants, the endogenous feedback effects of firm risk on CEO incentives, unobserved firm and market effects, and debt governance. The impact of CEO risk aversion is economically significant.

CEO Deferred Compensation Investment Decisions, Firm Risk, and Performance

We develop a novel approach of measuring CEO risk-aversion based on the personal allocation of their deferred compensation funds and find that CEO risk preferences influence firm risk. We also use the 2008 financial crisis as a natural experiment to check the robustness of this new approach and find consistent evidence in support of a positive association between CEO risk-taking and firm risk. Moreover, the evidence shows that risk-taking CEOs pursue risky financial and investment firm policies. Our results, in accord with the behavioral consistency theory, demonstrate that CEOs act consistently across personal and professional situations.

Managerial Incentives, Conservatism, and Debt

We investigate the risk choices of risk averse CEOs. Following recent theoretical work, we expect CEO risk aversion to be more pronounced in firms with high leverage, or high default probability. We find that the CEOs of these firms reduce firm risk, even in the presence of strong risk taking incentives. Our results are robust to controls for the sensitivity of CEO wealth to stock price changes, firm risk determinants, the endogenous feedback effects of firm risk on CEO incentives, unobserved firm and market effects, and debt governance. The impact of CEO risk aversion is economically significant.

Managerial Risk Preference and Firm Performance Volatility: New Evidence from Executive Deferred Compensation

Using novel data from executive deferred compensation, this paper presents new evidence on the relationship between CEO risk preference and firm risk (the volatility of firm performance measures such as stock return, earnings and operating cash flows). My results show a negative association between the CEO risk aversion (as measured by realized performance on inside debt) and the volatility of firm market performance: Firms with risk-averse CEOs have experience less stock price volatility. I also find that firms providing deferred compensation plans have lower performance volatility. The results contribute to the inside debt literature by showing that inside debt compensation is related to lower firm risk and lower firm market value.

Cultural Values, CEO Risk Aversion and Corporate Takeovers

We explicitly examine the role of culture in corporate takeover decisions. Prior research suggests that the risk aversion of CEOs affects their takeover decisions. In this paper, we argue that managerial risk aversion at a national level is a cultural trait and affects the net synergies. CEOs of firms located in countries with higher level of risk aversion, measured by Hofstede’s (2001) uncertainty avoidance score, show less takeover activity, engage more in diversifying takeovers and require higher premiums on takeovers. Required net synergies are higher for smaller firms, relatively larger deals, and for firms that engage in more takeover activity.

CEO Behavior and Subprime Mortgage Crisis

The paper addresses the subprime mortgage crisis from the perspective of the CEO of a financial firm. We integrate agency theory with the asset-pricing model to explore factors affecting CEO risk aversion. Apart from wealth and effort, the two main factors in influencing the agent’s risk preference, we also add a measure of CEO career concern to the model. Increasing peer pressure, high-incentive compensation structure, and declining market power diminish CEOs’ alertness to risk, resulting in a departure of CEO actions from firm value. For reining in CEOs’ excessive risk taking and aligning both interests of firms and CEOs, we suggest that the emphasis of the pay schedule should be adjusted according to market conditions, the relative performance evaluation be embedded into executive compensation, and the time span for performance evaluation be lengthened. The role of the board of directors and the function of risk management units should also be intensified.

Do Better-Connected CEOs Innovate More?

This paper presents evidence suggesting that CEO connections facilitate investments in corporate innovation. We find that firms with better-connected CEOs invest more in R&D and receive more and higher quality patents. Further tests suggest that this effect stems from two characteristics of personal networks that alleviate CEO risk aversion in corporate investment decisions. First, personal connections increase the CEO’s access to relevant network information, which encourages innovation by helping the CEO to identify, evaluate, and exploit innovative ideas. Second, personal connections provide the CEO with labor market insurance that facilitates investments in risky innovation by mitigating the career concerns inherent in such investments.

Tests of two optimal incentive models for executive stock options

Using a unique data set, we test theoretical propositions relating to grant size and exercise price in determination of optimal executive compensation. For Hall and Murphy, pay-performance sensitivity does not behave as predicted with respect to CEO risk aversion and diversification, but the latter supports observed grant size while ATM grants exhibit positive abnormal returns as predicted. Consistent with Choe, exercise price is found inversely related to leverage. The unexpected positive relation between grant size and stock volatility is conjectured driven by CEOs’ influencing large grants, which are found associated with weak corporate governance but ameliorated by outside directors.