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Idiosyncratic risk, risk-taking incentives and the relation between managerial ownership and firm value

Chris Florackis, Angelos Kanas, Alexandros Kostakis and Sushil Sainani

European Journal of Operational Research, 2020, vol. 283, issue 2, 748-766

Abstract: In addition to its well-documented alignment effect, managerial ownership can also have value-destroying effects by shifting risk to managers and encouraging risk-substitution; that is, managers with relatively unhedged personal portfolios tend to pass up profitable projects with high idiosyncratic (firm-specific) risk in favor of less-profitable projects that have greater aggregate (market) risk. Using parametric and semi-parametric estimation methods, we examine how managerial ownership influences firm value in light of the trade-off between the alignment and the risk-substitution effects. We find that risk-substitution offsets the alignment effect of managerial ownership in firms that are exposed to severe risk-substitution problems, leading to a weak (or non-existent) association between managerial ownership and firm value. We identify a plausible channel for these effects by showing that firms exposed to risk-substitution exhibit more “conservative” investment and financing policies. We also show that the risk-substitution problem is partially mitigated by the inclusion of stock options in managerial compensation packages. Finally, our findings suggest that semi-parametric methods may prove useful for future studies aiming at capturing nonlinear features in the data.

Keywords: Finance; Idiosyncratic risk; Risk-substitution; Managerial ownership; Semi-parametric estimation (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1016/j.ejor.2019.11.027

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