Working Paper: NBER ID: w16176
Authors: Inghaw Cheng; Harrison Hong; Jose A. Scheinkman
Abstract: We study the relationship between compensation and risk-taking among finance firms using a neglected insight from principal-agent contracting with hidden action and risk-averse agents. If the sensitivity of pay to stock price or slope does not vary with stock price volatility, then total compensation has to increase with firm risk to satisfy as agent's individual rationality constraint. Consistent with this hypothesis, we find a correlation between total executive compensation, controlling for firm size, and risk measures such as firm beta, return volatility, and exposure to the ABX sub-prime index. There is no relationship between insider ownership, a proxy for slope, and these measures. Compensation and firm risk are not related to governance variables. They increasewith institutional investor ownership, which suggests that heterogeneous investors incentivize firms to take varying levels of risks. Our results hold for non-finance firms and point to newprincipal-agent contracting empirics.
Keywords: compensation; risk-taking; finance firms; principal-agent theory; institutional investors
JEL Codes: G01; G21; G22; G24; G32
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| firm risk (G32) | total executive compensation (M12) |
| insider ownership (G34) | firm risk (G32) |
| institutional investor ownership (G23) | high compensation and risk-taking (M52) |
| investor preferences (G11) | higher compensation (J33) |