Managerial Performance Incentives and Firm Risk during Economic Expansions and Recessions*

Abstract

We argue that the relationship between managerial pay-for-performance incentives and risk taking is pro-cyclical. We study the relationship between incentives provided by stock-based compensation and firm risk for US non-financial corporations over the two business cycles between 1992 and 2009. We show that a given level of pay-for-performance incentives results in significantly lower firm risk when the economy is in a downturn. The documented pro-cyclical relationship between incentives and risk taking is consistent with state-dependent risk aversion. Our findings contribute to the literature on the depressive effects of performance incentives on firm risk by documenting the importance of the interaction between performance incentives and risk aversion.

Differential Risk‐taking Implications of Performance Incentives From Stock and Stock Option Holdings

“…Some earlier studies (Coles, Daniel, and Naveen ; Low ) find a positive correlation between vega and firm risk, whereas other studies find no significant relation (Hayes, Lemmon, and Qiu ). Yet, similar to the results here, more recent studies (Milidonis and Stathopoulos ; Savaser and Şişli‐Ciamarra ) report a significant negative relation between vega and risk. Milidonis and Stathopoulos () attribute the negative relation between vega and risk to managerial career concerns.…”

“…Although many theoretical models predict the risk‐reducing impact of managerial performance incentives documented in our findings, most empirical studies report either positive (Cohen, Dey, and Lys ; Coles, Daniel, and Naveen ; Armstrong and Vashishtha ; Savaser and Şişli‐Ciamarra ) or insignificant (Low ; Hayes, Lemmon, and Qiu ; Gormley, Matsa, and Milbourn ) coefficients on delta . As we discuss in the following sections, our analysis provides a possible explanation for the change in the delta coefficient's sign over our extended sample period.…”

“…Finally, to ensure that our results are not driven by changes in aggregate economic activity, we control for real gross domestic product (GDP) in our analysis. We use unrevised announcement values of the GDP advance release variable to capture the macroeconomic climate as perceived by firms during a fiscal year (Savaser and Şişli‐Ciamarra ). Seasonally adjusted real GDP growth rates are announced quarterly by the Bureau of Economic Analysis (BEA).…”

“…We also contribute to the literature by providing an explanation for the varying delta coefficient signs reported in empirical studies. Whereas some studies document a negative relation between delta and firm risk (Boyallian and Ruiz‐Verdú ), other studies find a positive relation (Cohen, Dey, and Lys ; Coles, Daniel, and Naveen ; Armstrong and Vashishtha ; Savaser and Şişli‐Ciamarra ) or an insignificant relation (Low ; Hayes, Lemmon, and Qiu ; Gormley, Matsa, and Milbourn ). Our proposed measure of relative pay‐for‐performance incentives (i.e., source ratio) highlights the risk‐taking implications of the compositional shifts that can occur in delta (e.g., due to regulatory changes) and provides an empirically more robust and consistent interpretation of the delta–firm risk relation.…”

“…The literature shows that the underlying macroeconomic conditions affect the relation between performance incentives and firm risk (Savaser and Şişli‐Ciamarra ). Because our sample period covers two recession periods, we also take into account the effect of economic conditions on managerial risk‐taking preferences by directly controlling for the level of macroeconomic activity.…”