CEO Compensation and Corporate Risk

The following post comes to us from Todd Gormley of the Department of Finance at the University of Pennsylvania, David Matsa of the Department of Finance at Northwestern University, and Todd Milbourn, Professor of Finance at Washington University in St. Louis.

Every firm is exposed to business risks, including the possibilities of large, adverse shocks to cash flows. Potential sources for such shocks abound—examples include disruptive product innovations, the relaxation of international trade barriers, and changes in government regulations. In our paper, CEO Compensation and Corporate Risk: Evidence from a Natural Experiment, forthcoming in the Journal of Accounting and Economics, we examine (1) how boards adjust CEOs’ exposure to their firms’ risk after the risk of such shocks increase and (2) how incentives given by the CEOs’ pre-existing portfolios of stock and options affect their firms’ response to this risk. Specifically, we study what happens when a firm learns that it is exposing workers to carcinogens, which increase the risks of significant corporate legal liability and costly workplace regulations.

The results presented in this paper suggest that corporate boards respond quickly to changes in their firms’ business risk by adjusting the structure of CEOs’ compensation, but that the changes only slowly impact the overall portfolio incentives CEOs face. After the unexpected increase in left-tail risk, corporate boards reduce CEOs exposure to their firms’ risk; the sensitivities of the flow of managers’ annual compensation to stock price movements and to return volatility decrease. Various factors likely contribute to the board’s decision, including CEOs’ reduced willingness to accept a large exposure to their firms’ risk and the decline in shareholders’ desired investment after left-tail risk increases. Indeed, managers act to further reduce their exposure to the firm’s risk by exercising more options than do managers of unexposed firms. These changes, however, only slowly move CEOs’ overall exposure to their firm’s risk because the magnitude of their pre-existing portfolios continues to influence their financial exposure to the firm.

The unanticipated increase in business risk also provides an opportunity to analyze options’ causal effect on corporate risk-taking. We use CEOs’ pre-existing portfolio of options and stock as a proxy for managers’ portfolio immediately after the carcinogens’ discovery; these incentives are predetermined with respect to the new risk environment and not subject to the reverse causality concerns that plague existing studies of compensation structure and risk. We find that CEOs with more convex payoffs tend not to offset the unexpected increase in risk through diversifying acquisitions, reducing leverage, cutting R&D expenditures, or by building up greater cash holdings. As a result, stock variance increases the most for high vega firms after the jump in tail risk. The findings are robust to numerous robustness checks and do not appear to be driven by omitted factors that might affect both the choice of compensation and firms’ responses to the increased risk.

Overall, our results show that options affect corporate risk-taking and highlight the importance of a board structuring its executives’ compensation packages to induce the desired level of risk taking. In addition, our results imply the novel insight that boards should design the convexity of managers’ compensation with an eye on potential changes in the company’s risk environment and how their executives will respond given their compensation. As our findings illustrate, more convex payoffs can dampen managerial incentives to offset unanticipated increases in business risk. Boards interested in encouraging more aggressive responses to future increases in business risk should use less convex payoffs, whereas other boards should use more convex payoffs if responding to increases in business risk is costly and undesirable to shareholders.

The full paper is available for download here.

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