The Impact of Managerial Risk Incentives on Investment Policies, Financial Policies and Firm Risk: Evidence from A Natural Experiment

Abstract

In past decades, the impact of CEO incentives has received much attention from scholars and practitioners. In particular, prior studies have investigated the impact of CEO risk incentives (vega) on firm risk. Prior studies have provided mixed empirical evidence on the impact of option-based compensation on risk-taking behaviour because both equity incentives and risk are endogenously determined, which makes it default to establish strong causality. In light of this, this research is an investigation into the impact of CEO risk incentives on investment policies, financing policies and firm risk. To overcome the endogeneity issue, applied quasi-natural experiments were conducted through the incentives shock in 2005 that instigated by the FAS 123R. This study is an investigation of a sample of the S&P 500 index from 1993 to 2014. The conclusions are based on OLS regressions and difference-in-difference regression employed as additional robustness tests. The baseline regressions show a positive association between vega and both R&D expenditures and the firm leverage ratio but a negative association between vega and both capital expenditures and stock-return volatility. However, these results are not in line with the DiD regression results. There is little evidence that the decline in vega after FAS 123R results in less risky investments. In general, this research could not gather sufficient evidence for a positive association between vega and risk-taking behaviour.