Executive Compensation Convexity and Firm Crash Risk

This paper demonstrates that executive compensation convexity, measured as the sensitivity of managerial equity compensation portfolios to stock volatility, predicts firm-specific crashes. A bottom-to-top decile change in compensation convexity results in a 21% increase in a firm's crash risk after controlling for managerial price-increasing incentives. In contrast, there is no robust evidence of a symmetric relation between compensation convexity and a firm's idiosyncratic positive jump risk. We exploit an exogenous shock to compensation convexity, arising from a change in the expensing treatment of executive stock options, in further supporting our interpretations within a natural experiment setting. Our results suggest that managerial equity compensation portfolios do not augment a firm's future idiosyncratic crash risk because they link managerial wealth to equity prices, but rather because they tie managerial wealth to the volatility of a firm's equity.