Executive Compensation, Managerial Risk Aversion, and the Choice of Risky Projects

Abstract

In this paper we examine the relation between executive compensation and managerial risk-taking. To account for the fact that managers cannot easily diversify their firm-specific human capital, we model managers as risk-averse. The compensation contracts we consider include three components: a fixed salary, shares of stock and stock options. We explore how managerial behavior varies with the parameters of the compensation contract. In this way, our model is an extension of John and John (1993). Our results suggest that typical compensation contracts, consisting of cash, shares, and at-the-money call options, encourage excessive risk-taking. We estimate the economic consequences of poorly designed compensation contracts and find that annual shareholder losses can easily exceed several hundred million dollars for a large corporation. Setting the strike prices on executive stock options substantially out-of-the-money can better align managers’ interests with those of shareholders and thus moderate excessive risk-taking behavior. Risktaking behavior is more stable when managers are compensated with out-of-the-money options, reducing the need to re-price the options.