Pay Performance Sensitivity And Risk: Theoretical And Empirical Study

The fundamental concern of the corporate governance is that the manager should be led to behave as the interests of the shareholder via incentives and supervisions, and one important way is to provide the manager the proper scheme of payment. In principal-agent theory, giving the manager performance pay is a useful procedure to motivate the manager to work harder. However, the incentive cost of performance pay will be increasing with the risk because the risk-averse manager is reluctant to bear more risk on himself. Therefore, the shareholder have to trade off between the incentive and the risk, which implies that in classical principal-agent model, the pay performance sensitivity should decrease in risk. That is, the more risk, the less incentive.However, many empirical studies on the relationship between the pay performance sensitivity and the risk didn't support the classical principal-agent theory, and some of them even provided negative evidence that the pay performance sensitivity increases with risk. How does it happen? In this paper, we argue that the classical principal-agent theory is built on some rigid assumptions, and once these assumptions don't hold, the relationship between the pay performance sensitivity and the risk might change. Therefore in this paper, we ask three questions as follows:1. Does the negative correlation between the pay performance sensitivity and the risk always hold or get some change under different conditions?2. What factors are possible to change the relationship between the pay performance sensitivity and the risk?3. How does the effect of these factors on the relationship between the pay performance sensitivity and the risk?The paper aims to give answers to the above questions. The basic conclusion is that the negative correlation between the pay performance sensitivity and the risk doesn't always hold, and the pay performance sensitivity will increase with risk under the influence of some factors. Thus, the pay performance sensitivity increasing with risk should not be regarded as an abnormal phenomenon or the deviation from the agent theory, and on the contrary, it might be the optimal...