Agency theory and executive compensation: A perspective on performance and risk

Agency theorists hold that the alignment of owners' expectations and executive actions have the potential to diverge therefore executive compensation plans are designed to align executive actions and owners' goals. The utility theory of microeconomics suggests that most individuals will try to minimize risks, but that other individuals are risk neutral or are risk seekers dependent on their personal marginal utility of money. There is support in the literature that the owners of a firm will perceive risk positively as it is associated with greater potential for growth. Executives of the firm, who are agents of risk-seeking owners, are more likely to be risk averse seeking to achieve higher short-term compensation and to avoid potential public and career embarrassment which may affect their personal human capital value. This paper proposes a study of the link between firm alpha, or firm-specific risk, and executive compensation as a test of agency theory by answering three interrelated questions. First, are changes in CEO compensation positively correlated with changes in stock alpha risk? Second, are changes in CEO compensation positively correlated with stock alpha risk when the market is rising? Third, are changes in CEO compensation negatively related to changes in stock alpha risk when the market is falling? Although the methodology in this research was unique, the results, unfortunately, are not. This research utilized a different perspective on performance measurement, but came to the same conclusion as the bulk of the body of prior research, specifically that CEO compensation is not reliably predictable by examining the operations or performance of the firm.