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Yesterday's Heroes: Compensation and Creative Risk-Taking

  • Ing-Haw Cheng
  • Harrison Hong
  • Jose A. Scheinkman

We study the relationship between compensation and risk-taking among finance firms using a neglected insight from principal-agent contracting with hidden action and risk-averse agents. If the sensitivity of pay to stock price or slope does not vary with stock price volatility, then total compensation has to increase with firm risk to satisfy as agent's individual rationality constraint. Consistent with this hypothesis, we find a correlation between total executive compensation, controlling for firm size, and risk measures such as firm beta, return volatility, and exposure to the ABX sub-prime index. There is no relationship between insider ownership, a proxy for slope, and these measures. Compensation and firm risk are not related to governance variables. They increasewith institutional investor ownership, which suggests that heterogeneous investors incentivize firms to take varying levels of risks. Our results hold for non-finance firms and point to newprincipal-agent contracting empirics.

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File URL: http://www.nber.org/papers/w16176.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16176.

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Date of creation: Jul 2010
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Publication status: published as Yesterday's Heroes: Compensation and Creative Risk-Taking , Ing-Haw Cheng, Harrison Hong, Jose Scheinkman. in Market Institutions and Financial Market Risk , Carey, Kashyap, Rajan, and Stulz. 2012
Handle: RePEc:nbr:nberwo:16176
Note: CF
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  1. Tobias Adrian & Hyun Song Shin, 2008. "Liquidity and leverage," Staff Reports 328, Federal Reserve Bank of New York.
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