Managerial Incentives and Risk-Taking

This paper provides empirical evidence of a strong causal relation between the structure of managerial compensation and investment policy, debt policy, and firm risk. Controlling for CEO pay-performance sensitivity (delta) and the feedback effects of firm policy and risk on the structure of the managerial compensation scheme, we find that higher sensitivity of CEO wealth to stock volatility (vega) implements riskier policy choices, including relatively more investment in Ramp;D, less investment in property, plant and equipment, more focus on fewer lines of business, and higher leverage. At the same time, we find that riskier policy choices in general lead to compensation structure with higher vega and lower delta. Stock-return volatility, however, has a positive effect on both vega and delta