Managerial Risk And Incentive Essay

840 words - 4 pages

1. Problem statement
The authors’ main focus is the sensitivity of CEO wealth to stock return volatility (vega). They find that the higher vega leads to riskier policies made by managers. Examples of risky policies are investment in research and development and high leverage. It indicates that vega is an incentive for executives to invest in riskier asset and more aggressive debt policy. Therefore, firms with high growth opportunities may want to increase vega to motivate managers to invest in high risk with positive NPV projects.
Another focus of this journal is the sensitivity of CEO wealth to stock price (delta). Equity-based compensation has grown so rapidly in recent years and raised delta. Delta is believed to align the interest of managers and shareholders because higher delta means that managers have to work harder to increase the share price so that their wealth also increases. By having a high delta, managers are exposed to more risk. Hence, managers may give up high NPV project if it is very risky. However, higher vega may offset the risk-aversion arise from high delta.
Based on this background, the authors’ main research question is whether higher vega leads to riskier investment and debt policy, and greater volatility of stock returns. The authors want to separate two opposite effects of vega and delta which are (1) the effect of compensation to investment and risk policy, and (2) the effect of those policies to the compensation of risk-averse manager.
Motivation & Literature Study
The theory behind this journal is the convex payoff theory which stated that manager’s pay is a convex function of profits if recipients get a greater increment in pay when returns are high. In order to get greater pay, managers will adopt risky investment projects, implement highly levered capital structures, and create new risk. Also, there have been a differing conclusions on the relation of managerial stock holding and return variance, it can be concluded that firms with higher equity-based compensation are engaged on more risk-increasing acquisitions (Agrawal and Mandelker, 1987). Although many researches have proved the association between compensation structure and firm risk, there is no empirical estimation of the core causal relation between vega and stock return volatility. Endogeneity problem may come up since there may be omitted primitive factors, such as pre-determined characteristics of the firm, that drive the correlation between vega and stock return volatility.
To control this difficulty, the authors assume that shareholders determine vega and delta to apply value-maximizing investment and risk policy. Then,...

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