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Does Executive Compensation Reflect Default Risk?

Author

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  • C, Loran

    () (UiS)

  • Eckbo, Espen

    (Darthmouth College)

  • Lu, Ching-Chih

    (National Chengchi University)

Abstract

We analyze whether executive compensation reflects firm default risk, measured by distance to default of Merton (1974). Using a large panel of firms, we explore several empirical frameworks. In least squares, fixed effects and quantile regression settings, default risk and volatility possess significant explanatory power for compensation. The signs of the estimated coefficients are consistent with higher compensation for higher risk-bearing--managers of firms with higher default risk are paid more. In the benchmark models, estimates for default risk are quite small, indicating effects on average compensation of around $9,000. The corresponding figure for the upper 5-percentile of CEOs is $50,000. Volatility has much larger average effects, in excess of $25 million, with upper 5-percent effects above $150 million. In a partial identification framework, compensation is systematically associated with default risk. Moving to a higher default risk firm raises compensation by at least $.96%, corresponding to around $70,000 for average CEOs, and above $400,000 for the top 5-percentile. The largest effect applies for moving into the highest default risk firms. For such firms, the treatment effect exceeds $180,000 for average CEOs, and for the top 5-percent, the effect is well above $1 million. Conditional means exhibit monotonicity, suggesting that compensation is amenable to a treatment response approach. Surprisingly, when we utilize an instrumental variables approach, an increase in default risk reduces total compensation. Thus our results uncover a complex but powerful link between firm risk and CEO compensation, which may make it difficult to regulate compensation by means such as `Say-on-Pay'.

Suggested Citation

  • C, Loran & Eckbo, Espen & Lu, Ching-Chih, 2014. "Does Executive Compensation Reflect Default Risk?," UiS Working Papers in Economics and Finance 2014/11, University of Stavanger.
  • Handle: RePEc:hhs:stavef:2014_011
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    References listed on IDEAS

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    Cited by:

    1. Brown, Jason L. & Farrington, Sukari & Sprinkle, Geoffrey B., 2016. "Biased self-assessments, feedback, and employees' compensation plan choices," Accounting, Organizations and Society, Elsevier, vol. 54(C), pages 45-59.
    2. John Deckop & Robert Giacalone & Carole Jurkiewicz, 2015. "Materialism and Workplace Behaviors: Does Wanting More Result in Less?," Social Indicators Research: An International and Interdisciplinary Journal for Quality-of-Life Measurement, Springer, vol. 121(3), pages 787-803, April.

    More about this item

    Keywords

    Default; Executive Compensation; Treatment Response; Partial Identification; Volatility;

    JEL classification:

    • A10 - General Economics and Teaching - - General Economics - - - General

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