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The Other Side of the Tradeoff: The Impact of Risk on Executive Compensation

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Author Info
Rajesh Aggarwal
Andrew A. Samwick

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Abstract

The principal-agent model of executive compensation is of central importance to the modern theory of the firm and corporate governance, yet the existing empirical evidence supporting it is quite weak. The key predication of the model is that the executive's pay-performance sensitivity is decreasing in the variance of the firm's performance. We demonstrate strong empirical confirmation of this prediction using a comprehensive sample of executives at large corporations. In general, the pay-performance sensitivity for executives at firms with the least volatile stock prices is an order of magnitude greater than the pay-performance sensitivity for executives at firms with the most volatile stock prices. This result holds for both chief executive officers and for other highly compensated executives. We further show that estimates of the pay-performance sensitivity that do not explicitly account for the effect of the variance of firm performance are biased toward zero. We also test for relative performance evaluation of executives against the performance of other firms. We find little support for the relative performance evaluation model. Our findings suggest that executive compensation contracts incorporate the benefits of risk-sharing but do not incorporate the potential informational advantages of relative performance evaluation.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 6634.

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Date of creation: Jul 1998
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Handle: RePEc:nbr:nberwo:6634

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Find related papers by JEL classification:
G30 - Financial Economics - - Corporate Finance and Governance - - - General
J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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  3. Shleifer, Andrei & Vishny, Robert W, 1997. " A Survey of Corporate Governance," Journal of Finance, American Finance Association, vol. 52(2), pages 737-83, June. [Downloadable!] (restricted)
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  4. Robert Gibbons & Kevin J. Murphy, 1990. "Relative performance evaluation for chief executive officers," Industrial and Labor Relations Review, ILR Review, ILR School, Cornell University, vol. 43(3), pages 30-51, February.
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  7. Brian J. Hall & Jeffrey B. Liebman, 1997. "Are CEOs Paid Like Bureaucrats?," Harvard Institute of Economic Research Working Papers 1789, Harvard - Institute of Economic Research.
  8. Koenker, Roger & Bassett, Gilbert, Jr, 1982. "Robust Tests for Heteroscedasticity Based on Regression Quantiles," Econometrica, Econometric Society, vol. 50(1), pages 43-61, January. [Downloadable!] (restricted)
  9. Haubrich, Joseph G, 1994. "Risk Aversion, Performance Pay, and the Principal-Agent Problem," Journal of Political Economy, University of Chicago Press, vol. 102(2), pages 258-76, April. [Downloadable!] (restricted)
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  10. Robert Gibbons & Kevin Murphy, 1989. "Relative Performance Evaluation for Chief Executive Officers," Working Papers 628, Princeton University, Department of Economics, Industrial Relations Section.. [Downloadable!]
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  11. Garen, John E, 1994. "Executive Compensation and Principal-Agent Theory," Journal of Political Economy, University of Chicago Press, vol. 102(6), pages 1175-99, December. [Downloadable!] (restricted)
  12. Brian J. Hall & Jeffrey B. Liebman, 1997. "Are CEOs Really Paid Like Bureaucrats?," NBER Working Papers 6213, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  13. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn. [Downloadable!] (restricted)
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