Differential risk effect of inside debt, CEO compensation diversification, and firm investment

Cheng Few Lee, Chengru Hu, Maggie Foley

Research output: Contribution to journalArticlepeer-review

3 Scopus citations

Abstract

The main purposes of this paper are to study (1) a differential effect of inside debts on components of the firm risk, and (2) how it relates to the diversification of CEOs’ portfolios to reduce exposures to the firm risk. We find that compensating CEOs with inside debts (e.g., pensions and other deferred compensation plans) leads to reductions in firms’ systematic risk and idiosyncratic risk, but to disproportionate degrees. CEOs with larger inside debts draft and implement policies, which lead to a significantly larger reduction in the idiosyncratic firm risk and investment. We then show that the differential effect is the result of an asymmetry in CEOs’ perceived benefits of diversifying exposures to individual firm risk components. We further show that granting excessive debt-based pay may divert executives from firm specific but productive activities (e.g., R&D investments), therefore may compromise the long-run corporate success.

Original languageEnglish (US)
Pages (from-to)505-543
Number of pages39
JournalReview of Quantitative Finance and Accounting
Volume56
Issue number2
DOIs
StatePublished - Feb 2021

All Science Journal Classification (ASJC) codes

  • Accounting
  • Business, Management and Accounting(all)
  • Finance

Keywords

  • Diversification
  • Executive compensation
  • Inside debt
  • R&D investment
  • Risk-taking incentive
  • Systematic and idiosyncratic risk

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