Asymmetric Risk and CEO Compensation

Abstract

This paper aims to understand how firms’ asymmetric risk environment affects the CEO compensation structure. I investigate how firm’s downside risk and upside potential differentially affect the choice between cash and equity compensation and the choice between stock options and restricted stock compensation. First, I show that, as downside risk (upside potential) increases, boards grant more cash compensation (more equity compensation) and less equity compensation (less cash compensation). Second, I show that the proportion of CEO option compensation in total equity compensation increases with downside risk and decreases with upside potential. My findings support the idea that boards respond to changes in their firms’ risk environments by adjusting the structure of CEO compensation to reflect risk-averse CEOs’ risk preferences.