Common vs. Firm-Specific Risks in Relative Performance Evaluation

This paper examines the trade-off between common and peers' specific risks in relative performance evaluation (RPE). We establish that in order to remove common risk completely from management compensation contracts, it is sufficient and necessary that peers' weighted specific risks are lower. Nonetheless, common risk needs not to be removed completely; the optimal use of RPE therefore entails a partial substitution of common for peers' specific risks unless firms can hedge against peers' specific risks. These results contribute to our understanding of factors affecting a firm's peer choices and provide specific implications for the weak- vs. strong-form RPE tests