The effect of CEO background risks on risk taking and firm performance

The motivation for this thesis is founded on the increasing studies on executive compensation as it relates to risk taking and firm performance which has resulted in inconclusive results. A large number of the empirical studies on executive pay have focused on agency theory alone to examine its effect on risk taking behaviour and firm performance. The purpose of this research is to contribute to existing knowledge on executive compensation by incorporating background risk theory as a means through which an understanding of executive compensation and its effects on risk taking and firm performance can be analysed. The background risk theory, suggest that the introduction of an additional risk when one has been committed to result in risk aversion. The study employs data from the London Stock Exchange with a sample of FTSE350 non-financial firms for the period 1997-2010. To achieve the objective of the study, the thesis is divided into three independent but related empirical chapters. The first examines the link between background risk and executive compensation-risk taking relationship. The second empirical chapter examines the effect of background risk on the relationship between executive compensation and firm performance. Lastly, the third empirical chapter examines some determinants of CEO background risk with a particular focus on CEO employment risk.
The findings of the first empirical chapter provide strong support for the background risk theory. The study finds that the presence of background risk results in lower risk taking by CEOs. In addition, the study provides instances where background risk combined with the risk in the compensation package leads to risk aversion and less risk taking by the CEO.
The second empirical chapter finds that even though compensation may result in better firm performance, the presence of additional risk known as background risk alters the relationship between compensation and firm performance. Specifically, the presence of background risk leads to a negative relationship between compensation and firm performance.
The findings of the first two empirical studies inspired further research on the determinants of CEO background risk. The findings reveal that large boards and independent boards, increase the likelihood of CEO employment risk. However, CEO network size reduces the likelihood of employment risk.