Two essays on managerial risk-seeking activities and compensation contracts
This dissertation examines how the structures of compensation for executives and directors are affected by the possibility that managers can influence the risk of a firm's cash flows. In chapter 1, I consider a moral hazard model which shows that a strong pay-for-performance sensitivity in managerial compensation may deteriorate shareholder value when shareholders cannot monitor managerial risk-seeking activities. Intuitively, while high-powered managerial compensation provides the manager with incentives to increase the firm's value by exerting effort, it also creates managerial incentive to engage in (unproductive) risk-seeking activities. To test this prediction, I consider a regulatory change that makes it more difficult for managers to conceal information about the (speculative) use of derivative instruments. Specifically, I examine how the structures of compensation for executives and managers are affected by the adoption of a new accounting standard, the Statement of Financial Accounting Standard No. 133 Accounting for Derivative Instruments and Hedging Activities (FAS 133) which mandates the fair value accounting for derivative holdings. Consistent with the model prediction, I find that relative to other firms, derivative users (firms that traded derivatives before adopting FAS 133) increase the pay-for-performance sensitivity of CEO/CFO compensation. In Chapter 2, I extend the model by incorporating the realistic features that shareholders delegate to the (self-interested) board the tasks of monitoring managers and of setting their compensation contracts. My analysis shows that while high-powered board compensation induces the board to monitor the firm and to properly design managerial compensation, it also provides the board with incentives to misreport managerial risk-seeking activities and to engage in collusive behavior with the manager at the expense of shareholders. From these trade-offs, I develop a number of testable hypotheses and take them to the data. Consistent with the model predictions, I find that firms in which (i) managerial risk-seeking activities are more likely to occur (e.g., high R&D firms or banks) and (ii) board monitoring costs are likely to be lower (e.g., firms that have non-officer blockholders on the board) show weaker pay-for-performance sensitivity of board compensation and stronger pay-for-performance sensitivity of CEO compensation.