Maintaining optimal CEO incentives through equity grants and CEO portfolio rebalancing

Abstract

My thesis examines the joint hypotheses that firms set optimal levels for CEO incentives, and that firms and CEOs jointly correct deviations from these optimal levels through equity grants and CEO portfolio rebalancing. I investigate two equity-based CEO incentives, pay-for-performance sensitivity and risk-taking incentive. Pay-for-performance sensitivity is defined as the change in CEO wealth for a given change in the firm's stock price, while risk-taking incentive the sensitivity of CEO wealth to equity risk. Chapter One examines the relation between incentive deviations and subsequent incentive adjustments based on Black-Scholes model (1973). I use this model to estimate both the incentives from CEOs' equity holdings and adjustments to these incentives. I find that firms' and CEOs' combined annual adjustment to pay-for-performance sensitivity or risk-taking incentive is negatively related to the degree that each incentive deviates from its target level at the beginning of the year, consistent with firms and CEOs jointly correcting the incentive deviations. Overall, the findings suggest that firms and CEOs coordinate their equity-granting and portfolio-rebalancing decisions to manage optimal CEO incentive levels consistent with economic theory. Chapter Two examines the relation between incentive deviations and subsequent incentive adjustments based on a certainty-equivalent approach. I only use this alternative approach to re-estimate incentive deviations, and still use Black-Scholes model to calculate incentive adjustments. The results support my findings in Chapter One.