Compensation, Convexity, and the Incentives to Manage Risk: An Empirical Analysis
Posted: 13 Jun 1997
Date Written: February 1997
Abstract
To control risk-related stockholder/manager agency conflicts effectively, equity holders are expected to manage, in addition to the pay-performance slope, the convexity of the relation between firm performance and managers' wealth. I examine the stock-based compensation of 278 corporate CEOs and find stock options play an economically significant role in increasing the convexity of the wealth-performance relation. The magnitude of the convexity provided by common stock is several orders of magnitude lower than that of stock options and of little economic importance for most CEOs in the sample. In cross-sectional tests, after controlling for the slope of the pay-performance relation, convexity is positively related to the proportion of growth options in firms' investment opportunity sets. This is consistent with firms providing managers with incentives to take risky projects when the potential loss from underinvestment in valuable risk projects is greatest. Convexity is also found to be negatively related to financial leverage and positively related to firm size. This result supports extant risk-management theory, and is consistent with firms providing managers with lower risk- taking incentives when the value created from hedging is likely to be greatest.
JEL Classification: J33, G30, G31
Suggested Citation: Suggested Citation