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Differential risk effect of inside debt, CEO compensation diversification, and firm investment

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  • Cheng-Few Lee

    (Rutgers University)

  • Chengru Hu

    (SUNY at Canton)

  • Maggie Foley

    (Jacksonville University)

Abstract

The main purposes of this paper are to study (1) a differential effect of inside debts on components of the firm risk, and (2) how it relates to the diversification of CEOs’ portfolios to reduce exposures to the firm risk. We find that compensating CEOs with inside debts (e.g., pensions and other deferred compensation plans) leads to reductions in firms’ systematic risk and idiosyncratic risk, but to disproportionate degrees. CEOs with larger inside debts draft and implement policies, which lead to a significantly larger reduction in the idiosyncratic firm risk and investment. We then show that the differential effect is the result of an asymmetry in CEOs’ perceived benefits of diversifying exposures to individual firm risk components. We further show that granting excessive debt-based pay may divert executives from firm specific but productive activities (e.g., R&D investments), therefore may compromise the long-run corporate success.

Suggested Citation

  • Cheng-Few Lee & Chengru Hu & Maggie Foley, 2021. "Differential risk effect of inside debt, CEO compensation diversification, and firm investment," Review of Quantitative Finance and Accounting, Springer, vol. 56(2), pages 505-543, February.
    • Handle: RePEc:kap:rqfnac:v:56:y:2021:i:2:d:10.1007_s11156-020-00901-0
    DOI: 10.1007/s11156-020-00901-0
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    More about this item

    Keywords

    Executive compensation; Inside debt; Risk-taking incentive; Systematic and idiosyncratic risk; R&D investment; Diversification;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
    • L25 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Performance
    • M12 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - Personnel Management; Executives; Executive Compensation

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