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Moving Closer to the Action: Examining Compensation Design Effects on Firm Risk

Wisconsin School of Business, University of Wisconsin–Madison, Madison, Wisconsin 53706
Department of Management, Eli Broad Graduate School of Management, Michigan State University, East Lansing, Michigan 48824
Department of Management, Eli Broad Graduate School of Management, Michigan State University, East Lansing, Michigan 48824
School of Global Management and Leadership, Arizona State University, Phoenix, Arizona 85069
cdevers{at}bus.wisc.edu
mcnamara{at}bus.msu.edu
wiseman{at}bus.msu.edu
mathias.arrfelt{at}asu.edu

We examine the influence of CEO equity-based compensation on strategic risk taking by the firm. Building off the Behavioral Agency Model, Agency Theory, and Prospect Theory, we develop arguments about when equity-based compensation elements will increase or decrease executive risk propensity and, in turn, strategic risk taking. Incorporating a behavioral perspective into our models of incentive alignment provides us with new and potentially more accurate predictions about how individual elements of CEO pay will influence risk selection, as well as how equity compensation interacts with cash compensation and with other factors to influence risk preferences. In general, this study provides evidence that CEO equity-based compensation significantly influences strategic risk, but that this influence is more nuanced and complex than conventional treatments of executive compensation assume. In particular, we find that different forms of equity-based pay exhibit dissimilar influences on strategic risk and that their influence changes as their value and vesting status change. Second, we find that cash-based forms of pay moderate the incentive properties of equity-based pay, indicating that cash-based pay may affect how executives perceive risks associated with equity pay. Finally, we find that stock price volatility and board actions each also moderate the incentive effects of equity-based pay. In sum, our results argue for increased recognition of a behavioral perspective on executive compensation and greater precision in how we measure and model the incentive alignment properties of CEO compensation.

Key Words: incentive alignment; CEO compensation; corporate governance; strategic risk