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How Important Are Risk-Taking Incentives in Executive Compensation?

Author

Listed:
  • Ingolf Dittmann
  • Ko-Chia Yu
  • Dan Zhang

Abstract

We consider a model in which shareholders provide a risk-averse CEO with risk-taking incentives in addition to effort incentives. We show that the optimal contract protects the CEO from losses for bad outcomes and is convex for medium outcomes and concave for good outcomes. We calibrate the model to data on 1,707 CEOs and show that it explains observed contracts much better than the standard model without risk-taking incentives. When we apply the model to contracts that consist of base salary, stock, and options, the results suggest that options should be issued in the money. Our model also helps us rationalize the universal use of at-the-money options when the tax code is taken into account. Moreover, we propose a new way of measuring risk-taking incentives in which the expected value added to the firm is traded off against the additional risk a CEO has to bear.

Suggested Citation

  • Ingolf Dittmann & Ko-Chia Yu & Dan Zhang, 2017. "How Important Are Risk-Taking Incentives in Executive Compensation?," Review of Finance, European Finance Association, vol. 21(5), pages 1805-1846.
    • Handle: RePEc:oup:revfin:v:21:y:2017:i:5:p:1805-1846.
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    File URL: http://hdl.handle.net/10.1093/rof/rfx019
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    Cited by:

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    2. Gabaix, Xavier & Sannikov, Yuliy & Edmans, Alex & Sadzik, Tomasz, 2009. "Dynamic Incentive Accounts," CEPR Discussion Papers 7497, C.E.P.R. Discussion Papers.
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    6. Karpavičius, Sigitas & Yu, Fan, 2018. "The impact of dividend-protected CEO equity incentives on firm value and risk," Economic Modelling, Elsevier, vol. 71(C), pages 16-24.
    7. Peter Slade & Tor Tolhurst, 2019. "Job Security and Risk‐Taking: Theory and Evidence From Professional Football," Southern Economic Journal, John Wiley & Sons, vol. 85(3), pages 899-918, January.
    8. Chaigneau, Pierre, 2018. "The optimal timing of CEO compensation," Finance Research Letters, Elsevier, vol. 24(C), pages 90-94.
    9. Chakraborti, Rajdeep & Dahiya, Sandeep & Ge, Lei & Gete, Pedro, 2024. "A model of managerial compensation, firm leverage and credit stimulus," Journal of Financial Stability, Elsevier, vol. 72(C).
    10. Chaigneau, Pierre, 2013. "Explaining the structure of CEO incentive pay with decreasing relative risk aversion," Journal of Economics and Business, Elsevier, vol. 67(C), pages 4-23.
    11. Gabaix, Xavier & Edmans, Alex, 2010. "Risk and the CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOs?," CEPR Discussion Papers 7836, C.E.P.R. Discussion Papers.
    12. Dunbar, Craig & Li, Zhichuan (Frank) & Shi, Yaqi, 2020. "CEO risk-taking incentives and corporate social responsibility," Journal of Corporate Finance, Elsevier, vol. 64(C).
    13. Islam, Emdad & Rahman, Lubna, 2023. "Shades of grey: Risk-related agency conflicts and corporate innovation," Journal of Corporate Finance, Elsevier, vol. 83(C).
    14. Chesney, Marc & Stromberg, Jacob & Wagner, Alexander F. & Wolff, Vincent, 2020. "Managerial incentives to take asset risk," Journal of Corporate Finance, Elsevier, vol. 65(C).
    15. Alex Edmans & Xavier Gabaix, 2016. "Executive Compensation: A Modern Primer," Journal of Economic Literature, American Economic Association, vol. 54(4), pages 1232-1287, December.
    16. Pierre Chaigneau, 2012. "The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts," Cahiers de recherche 1209, CIRPEE.
    17. Chaigneau, Pierre, 2013. "Risk-shifting and the regulation of bank CEOs’ compensation," Journal of Financial Stability, Elsevier, vol. 9(4), pages 778-789.
    18. Weixiu Li & Bo Li, 2023. "Intellectual Property Pledge Financing and Enterprise Innovation: Based on the Perspective of Signal Incentive," Sustainability, MDPI, vol. 15(13), pages 1-21, July.
    19. Harris, Oneil & Glegg, Charmaine & Buckley, Winston, 2019. "Do co-opted boards enhance or reduce R&D productivity?," The North American Journal of Economics and Finance, Elsevier, vol. 50(C).

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    More about this item

    Keywords

    Stock options; Effort aversion; Executive compensation; Risk aversion; Risk-taking incentives; Optimal strike price;
    All these keywords.

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

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