Do CEOs Possess any Extraordinary Ability? Can Those Abilities Justify CEO Pay?

• In Event: Executive Compensation I

Abstract

Do CEOs possess any extraordinary ability critical to organizational success? Do CEOs receive extraordinarily large pay because of their unique abilities? I examine those questions using the setting of CEOs’ ability to forecast future firm risks, because over the last 30 years, firm survival and success has become highly dependent firms’ preparedness to face uncertain future business environments. I measure CEOs’ risk-forecasting ability by the information contained in their personal equity trades. I find that on average, CEOs’ earlier-than-normal stock-option exercises are followed by increases in firms’ stock-return volatility. A battery of tests show that the earliness of those option exercises often represent CEOs’ personal portfolios adjustments in anticipation of future risks unknown to the market today, suggesting that on average, CEOs can forecast future firm risks better than the market can. In addition, results suggest that firms link long-term compensation to CEOs’ risk forecasting abilities, arguably to attract CEOs with better risk forecasting abilities and/or to channelize their abilities/efforts toward improving firms’ long-range planning. My study suggests that at least in this respect, CEO pay is related to an ability that has become an increasingly important determinant of firm success.

Author

• Anup Srivastava, Northwestern University