CEO compensation and corporate risk: Evidence from a natural experiment

- Convex managerial payoffs and firm risk are known to be correlated, but the direction of causality remains unclear.
- We exploit a change in risk to show how boards adjust incentives and how these incentives affect managers' risk-taking.
- We find that firms reduce managers' exposure to stock price movements after left-tail risk increases.
- Because the change in risk is unanticipated, we can also identify compensation's effect on risk-taking in the new environment.
- Our results show that convexity from options can encourage risk-taking in corporate investment and financing decisions.

This paper examines the two-way relationship between managerial compensation and corporate risk by exploiting an unanticipated change in firms' business risks. The natural experiment provides an opportunity to examine two classic questions related to incentives and risk-how boards adjust incentives in response to firms' risk and how these incentives affect managers' risk-taking. We find that, after left-tail risk increases, boards reduce managers' exposure to stock price movements and that less convexity from options-based pay leads to greater risk-reducing activities. Specifically, managers with less convex payoffs tend to cut leverage and R&D, stockpile cash, and engage in more diversifying acquisitions.