Controllability of risk and the design of incentive-compensation contracts

• Main Authors: ARMSTRONG, Christopher, GLAESER, Stephen, HUANG, Sterling
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2019
• Subjects: executive compensation; contract design; equity incentives; risk-taking incentives; stock options; derivatives; hedging; natural experiment; Accounting
• Online Access: https://ink.library.smu.edu.sg/soa_research/1866; https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?article=2893&context=soa_research
• Institution: Singapore Management University

We examine how executives’ ability to control their firm’s exposure to risk affects the design of their incentive-compensation contracts. We use the introduction of exchanged-traded weather derivatives, which improved executives’ ability to control their firms’ exposure to weather risk, as a natural experiment. We find that executives for whom weather derivatives have the greatest impact on their ability to control their firm’s exposure to weather risk experience relative reductions in total compensation and equity incentives. The former finding is consistent with a reduction in the risk premium that executives receive for their exposure to weather risk. The latter finding suggests that risk and incentives are complements when executives can control their firms’ exposure to risk. Collectively, our results show that executives’ ability to control their firms’ exposure to risk alters the nature of agency conflicts and influences the design of their incentivecompensation contracts.