An Empirical Analysis of CEO Risk Aversion and the Propensity to Smooth Earnings Volatility

Abstract

Volatility of firm performance is one measure of firm-specific risk that is priced in the marketplace. Because CEOs are typically undiversified investors in their companies' stocks, the negative valuation effects of this risk are asserted to provide them the incentive to reduce earnings volatility. Furthermore, such an incentive is expected to increase in risk aversion. Two alternative measures of risk aversion are generated: one derives from wealth, and the other derives from CEOs' choice of compensation structure as to the risky and safe components. The results consistently show a negative relationship between risk aversion and the volatility of each performance measure: earnings and operating cash flows. The results survived several tests of robustness. However, industry analysis shows that these results do not hold for certain industries such as public utilities.