CEO risk incentives and corporate cash holdings

Abstract

We empirically test the risk-reduction hypothesis of the agency theory in the context of corporate cash holdings. Since corporate cash holdings can be viewed as risk-free investments, the risk-reduction hypothesis predicts that a risk-averse and self-interested CEO allocates more firm assets to corporate cash holdings to reduce firm risk at the expense of giving up some positive NPV but risky projects, which is not beneficial to shareholders. We use the sensitivity of the value of a CEO’s stock options to stock return volatility (Executive Stock Options risk incentives) to study the relation between a CEO’s risk incentives and corporate cash holdings. We find that firms with lower ESO risk incentives have more corporate cash holdings. We find that more corporate cash holdings reduce firm risk, and that corporate cash holdings have a negative marginal impact on firm value due to the risk-related agency problem. These findings are consistent with the risk-reduction hypothesis of the agency theory in the context of corporate cash holdings.