Differential Effect of Inside Debt, CEO Compensation Diversification, and Firm Investment

Cheng Few Lee, Chengru Hu and Maggie Foley

Chapter 110 in Handbook of Investment Analysis, Portfolio Management, and Financial Derivatives:In 4 Volumes, 2024, pp 3627-3680 from World Scientific Publishing Co. Pte. Ltd.

Abstract: The main purposes of this paper are to study (1) a differential effect of inside debt on components of firm risk, and (2) how it relates to CEO portfolio diversification to reduce firm risk exposure. We find that compensating CEOs with inside debt (e.g., pensions and other deferred compensation plans) leads to reductions in firms’ systematic risk and idiosyncratic risk, but to disproportionate degrees. CEOs with larger inside debt draft and implement policies, which lead to a significantly larger reduction in the idiosyncratic firm risk and investment. We then show that the differential effect is the result of an asymmetry in CEOs’ perceived benefits of diversifying exposures to individual firm risk components. We further show that granting excessive debt-based pay may divert executives from firm specific but productive activities (e.g., R&D investments), therefore may compromise longrun corporate success.

Keywords: Financial Accounting; Financial Auditing; Mutual Funds; Hedge Funds; Asset Pricing; Options; Portfolio Analysis; Risk Management; Investment Analysis; Momentum Analysis; Behavior Analysis; Futures; Index Futures; CDCs; Financial Econometrics; Statistics; Financial Derivatives; Financial Accounting (search for similar items in EconPapers)
JEL-codes: G1 G11 G12 G3 M41 M42 (search for similar items in EconPapers)
Date: 2024
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