Three Essays on Executive Compensation - KOPS - Universität ...

Executive Compensation and Firm Performance in Germany
firm risk. Cichello (2005) argues that one has to explicitly account for firm size when
using the variance of stock market value as a measure for firm risk. For CEOs of U.S.
corporations during 1993-2000, he finds that the negative relationship between firm
risk and pay-performance sensitivity still holds, but pay-performance sensitivity is
smaller for CEOs of larger firms.
These findings are empirical support for Holmström and Milgrom’s (1987, 1991)
hypothesis of a negative relationship between firm risk and pay-performance sensitivity.
However, the empirical evidence is not always supportive. Instead of measuring
pay-performance sensitivity directly, Core and Guay (1999) look at company stock
and option grants to executives as an alternative measure for the degree to which
executive compensation is linked to firm performance. They find a positive impact
of firm risk, measured by stock return volatility, on the degree to which firms let
executives participate in firm performance with stock and option grants. They argue
that monitoring executives is costlier in firms operating in a risky environment.
As a substitute, owners of riskier firms provide executives with more incentives to
make sure they work toward firm value maximization.
Prendergast (2002) makes a similar argument. He surveys the empirical literature
on the relationship between risk and incentives and concludes that empirical
evidence in support of Holmström and Milgrom’s (1987, 1991) prediction of a negative
relationship between firm risk and pay-performance sensitivity is limited. His
explanation for a positive relationship is that shareholders of firms operating in environments
with a lot of uncertainty (risky firms) give managers more discretion
over the choice of activities. The intuition is that uncertainty makes shareholders
less confident how the management should operate the daily business of the firm
and therefore they delegate more responsibility. This delegation is accompanied
by output-based incentives and hence a positive relationship between firm risk and
pay-performance sensitivity.
In this study we analyze pay-performance sensitivity based on stock market
and accounting measures of firm performance. Therefore our work is also related
to studies from the accounting literature about the use of different performance
measures in executive compensation. Lambert and Larcker (1987) argue that the
relative weight placed on performance measures in executive compensation should
be related to the measure noisiness. They find that U.S. firms in the period 1970-
1984 indeed place relatively more weight on stock market performance if its variance
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