We examine if and how corporate social responsibility (CSR) affects the relation between risk taking incentives of CEO compensation (i.e. vega of CEO compensation) and measures of firm risk. Empirical results show that vega has a positive and significant effect on firm risk only in low CSR firms that attempt to maximize only investing stakeholders’ interests. In high CSR firms, that attempt to balance the interests of both investing and non-investing stakeholders, vega has no effect on firm risk. These findings are consistent with previous work that finds that CSR goals alter firm behavior as it tries to accommodate the (often divergent) interests of other stakeholders beyond the traditional shareholders.

Introduction

The relation between CEO risking taking incentives from performance based compensation and firm risk has been extensively studied in the literature. Most of the studies examine how incentives from CEO compensation encourage risk taking. In modern corporations where ownership and control are separate, managerial interests do not always align with shareholders’ interests. The agency theory (Jensen and Meckling, 1976) suggests that linking managerial compensation to firm performance by adding stock options helps in aligning managerial and shareholder interests. Since option values increase with stock price (delta of compensation), they provide incentives to managers to exert optimal effort. At the same time, options may also result in sub-optimal investment decisions (Amihud and Lev, 1981; Smith and Stulz, 1985) by exposing the already undiversified managers to more firm specific risk. However, options also increase in value with stock return volatility due to their convex pay offs. This effect (known as vega of compensation) incentivizes managers to increase firm risk. While there is conflicting evidence on how delta affects firm risk, almost all of the studies find a positive relation between vega and firm risk (see for example Tufano, 1996; Guay, 1999; Rajgopal and Shevlin, 2002; Coles et al., 2006). Although there has been a significant amount of work on CEO incentive compensation, most of this work is based on the agency theory framework (Jensen and Meckling, 1976) which assumes shareholder wealth maximization as the primary goal of a firm. Recent work on corporate social responsibility (CSR), however points to a shifting of this singular focus on shareholder wealth maximization, partly because of the role of corporate social activism. This literature shows that firms that invest in CSR may not maximize only shareholder wealth. In fact, firms that perform high on CSR intentionally attempt to balance the interests of all stakeholders (Freeman, 1984). These stakeholders include both the investing (shareholders) and the non-investing (employees, suppliers, customers, community, etc.) stakeholders. In this study, we investigate whether this broader goal of CSR affects the well-established relation between managerial risk taking incentives and firm risk. Specifically, we examine whether vega of CEO compensation affects firm risk differently in firms that perform high on CSR. This is important because firms that perform high on CSR are different from firms that perform low on CSR, and as such, managerial response to a change in vega might be different in these firms.