A trade-off between non-fundamental risk and incentives

This study conjectures that CEOs are rewarded more heavily for fundamental than for non-fundamental performance, and that the impact of non-fundamental risks is more negative than that of fundamental risks on pay-performance sensitivity. While the first conjecture stems from the controllability principle, the second conjecture is attributable to the interplay between the risk-incentive trade-off and delegation of responsibility to the agent. This study devised measures for fundamental and non-fundamental performance using an ARIMA-based unobserved-component approach. The two conjectures are strongly supported by this study’s findings over a wide range of empirical specifications, indicating that the optimal level of pay-performance sensitivity depends not only on the degree, but also on the nature, of performance uncertainty.