Executive Compensation and Managerial Risk-Taking

Abstract

This paper provides empirical evidence of a strong relation between the structure of managerial compensation and both investment policy and debt policy. Higher sensitivity of CEO wealth to stock volatility (vega) is associated with riskier policy choices, including relatively more investment in R&D, more focus on fewer lines of business, and higher leverage. These results are consistent with the hypothesis that higher vega in the managerial compensation scheme gives executives the incentive to implement policy choices that increase risk. Our results also indicate that these investment and financial policy choices are among the primary mechanisms through which vega affects stock price volatility.