Journal Pre-proof

Foreign competition and CEO risk-incentive compensation

Tor-Erik Bakke, Felix Zhiyu Feng, Hamed Mahmudi, Caroline H.

Zhu

PII: S0929-1199(22)00084-0
DOI: https://doi.org/10.1016/j.jcorpfin.2022.102241
Reference: CORFIN 102241

To appear in: Journal of Corporate Finance

Received date: 20 January 2021

Revised date: 2 July 2022
Accepted date: 5 July 2022

Please cite this article as: T.-E. Bakke, F.Z. Feng, H. Mahmudi, et al., Foreign competition
and CEO risk-incentive compensation, Journal of Corporate Finance (2022),
https://doi.org/10.1016/j.jcorpfin.2022.102241

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© 2022 Published by Elsevier B.V.

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Foreign Competition and CEO Risk-Incentive Compensation

Tor-Erik Bakkea,* tbakke@uic.edu, Felix Zhiyu Fengb ffeng@uw.edu, Hamed Mahmudic

d
hmahmudi@udel.edu, and Caroline H. Zhu zhu@spu.edu

a
University of Illinois at Chicago. Address: 106 Mitchell Cir, Wheaton, IL 60189

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b
University of Washington

c
University of Delaware

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Pacific University

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*
Corresponding author.
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Abstract
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How do firms modify CEO risk-incentive compensation in response to increased

foreign competition? Theoretically we show the answer is ambiguous: increased
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competition can result in firms either increasing or decreasing the CEO’s risk-taking
incentives. Empirically using a quasi-natural experiment, tariff cuts resulting from
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important trade deals, we find evidence that in response to increases in foreign

competition firms adjust CEO risk-incentive compensation downwards – a result that is
more pronounced for firms with less risk-averse CEOs. These findings suggest that
more intense foreign competition results in managers voluntarily taking on more risk,
and firms therefore reduce the convexity in managers’ compensation.

JEL Classification
G32; J33; F13; F16
Keywords
Executive Compensation, Risk-Incentive Compensation, Foreign Competition
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1 Introduction
In the past decades there has been a trend towards increased product market competition driven
by factors such as reductions in trade barriers, improved logistics, globalization and deregulation. More
intense competition can affect firm profits and risk and therefore could have a significant impact on CEO
incentives (Hermalin (1992), Schmidt (1997), Raith (2003)). In line with this, Cuñat and Guadalupe
(2005, 2009a and 2009b) show that firms respond to increased competition by adjusting the CEO’s total
pay, pay structure and performance-based pay. However, there is little work that explores whether boards

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respond to increased product market competition by changing the CEO’s risk-incentive pay. Such a
response is natural as changes in competition are also likely to impact the CEO’s and the shareholders’

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preference for risk. Using a shock to the level of foreign competition, we study the effect of changes in
product market competition on CEO option pay as the convex payoffs structure of CEO option

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compensation make them a useful tool through which under-diversified and risk-averse managers can be
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induced to take more risk.1
We use a quasi-natural experiment to investigate how firms adjust CEO risk-taking incentives in
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response to greater competition in the firm’s product market induced by increased foreign competition.
The evidence indicates that the increases in foreign competition lead to firms reducing CEO risk-incentive
pay – a result that is strengthened for firms with less risk-averse CEOs. This result illustrates that boards
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of directors adjust the structure of pay in response to exogenous shocks that affect risk. It also suggests
that the increasing use of option pay in the 90s and early 00s (Murphy (1999), (2013)) happened despite,
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not because of, the increase in foreign competition during the same period.
Product market competition can have either a positive or negative effect on CEO risk-taking
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incentive pay. The positive effect arises since higher competition increases the shareholders’ preference
for risk, leading firms to offer larger option grants to incentivize managers to take on more risk. The
negative effect can be understood by considering that higher competition increases the marginal value of
the manager’s existing option grants which leads managers to voluntarily take on more risk, and they
therefore do not need to be incentivized with as much option pay. An important factor determining
whether the positive or negative effect dominates is likely the manager’s appetite towards risk. In
response to increases in product market competition, a more risk-averse manager would not increase firm
risk sufficiently and would have to be incentivized with more option compensation. In contrast, a less

1 Recentempirical evidence shows that changing CEO option pay leads to changes in manager risk-taking behavior (Chava and
Purnanandam (2010), Gormley, Matsa and Milbourn (2013) and Bakke, Mahmudi, Fernando and Salas (2016)).
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risk-averse manager would voluntarily increase risk-taking such that it would be optimal for the
shareholders to offer him less risk-taking incentives.
To determine which effect dominates empirically, we study how boards adjust CEO risk-taking
incentives in response to intensifying foreign competition. In this context, establishing causality between
product market competition and CEO risk-taking incentives is difficult as executive risk-taking behavior
and option pay are endogenously determined. One source of bias is the two-sided matching between firms
and executives in the CEO labor market (e.g., less risk-averse CEOs may prefer higher risk-incentive
compensation and may also choose to work in more competitive industries). In addition, there could be
unobservable time-varying firm or industry characteristics that simultaneously affect both the level of
foreign competition and managerial compensation in an industry, potentially resulting in omitted

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variables bias. Finally, reverse causality is a concern. Granting the CEO more risk-incentive

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compensation can affect corporate decisions such as investment, merger policies and product market
strategies which may lead to more intense competition in the industry.

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We use a quasi-natural experiment to overcome these endogeneity concerns and identify a causal
effect of an increase in product market competition – induced by increased foreign competition - on risk-
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incentive compensation. The experiment focuses on the implementation of two major trade deals (FTAs)
in the mid-90s. The first is the North American Free Trade Agreement (NAFTA) which upon being
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ratified in late 1993 resulted in large tariff cuts to Mexican imports.2 The second contemporaneous trade
deal was the conclusion of the global Uruguay round, which committed all countries to broad and deep
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tariff cuts. Agreement on the Uruguay deal was reached in late 1993 and it was ratified in 1994.
Both these trade deals led to large tariff cuts in some industries, but left tariffs largely unchanged
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in others. We compare the effect of the increase in competition for firms in industries that experienced
sharp cuts in tariffs (treated firms) to propensity score matched control firms in industries that were
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largely unaffected by tariff cuts. We observe that whereas tariffs drop sharply for the treated firms (from
3.5% to 1%), they do not change for control firms. Moreover, competition, proxied by import penetration,
increases a statistically significant 0.0115 (a relative change of 10.11%) more for treated firms relative to
control firms around the tariff cuts. 3 This suggests that the reduced trade barriers lead to increased
competition via increased foreign entry into the domestic product markets (Bernard, Jensen, and Schott,

2 NAFTA was a free trade agreement (FTA) between the United States, Canada and Mexico. However, tariffs between the US
and Canada were largely eliminated by an FTA in the late 80s. For this reason, NAFTA only cut tariffs on imports from Mexico.
However, NAFTA did remove non-tariff trade barriers and increase the protection of intellectual property rights between Canada
and the US.
3
The source of exogenous variation in product market competition in our study is the intensification of foreign competition.
Thus, we measure competition using import penetration faced by US firms rather than measures of domestic competition such as
industry Herfindahl index.
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2006). This constitutes compelling evidence that the treated firms indeed experienced increased foreign
competition around the tariff cuts relative to control firms. 4
To convincingly identify the causal link between product market competition and CEO risk-
taking incentives, the tariff cuts should only affect CEO risk-taking incentives through an increase in
product market competition induced by increased foreign entry. That is, the increases in foreign
competition following the implementation of FTAs should be exogenous to CEO option pay. The
evidence suggests that this is indeed the case. First, it is unlikely that firms in industries in which tariffs
were cut lobbied in favor of tariffs cuts (they are more likely to have lobbied in favor of continued
protection). Second, as argued in Krugman, Obstfeld and Melitz (2015), firms are less likely to be able to
influence terms of large multi-national trade deals such as NAFTA or the Uruguay round. For these

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reasons it is less likely that the interaction between firms and politicians determined the timing and nature

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of the tariff cuts. Third, the evidence suggests that the tariff cuts were largely unanticipated (e.g., Fresard,
(2010), Valta (2012) and Fresard and Valta (2016)). There was significant uncertainty regarding whether

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NAFTA would pass in late 1993 right up to the contentious vote in the House on November 17, 1993.
Moreover, even in mid-1993 there was uncertainty about what (if anything) would be the outcome of the
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Uruguay of global trade negotiations and when an eventual consensus (if any) would be agreed on. This
makes it less likely that our findings are contaminated by firms adjusting option compensation in
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anticipation of the FTAs. Fourth, we confirm that in the pre-shock period treated and control firms are
both similar in observable firm characteristics and exhibit statistically similar trends in CEO risk-
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incentive pay prior to the tariff cuts. Fifth, we show that our results are unlikely to be driven by changes
in exports around the tariff cuts. Sixth, we analyze detailed supply chain data to show that our results are
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not driven by tariff cuts having spillover effects on firms that are supplier and/or customer of our treated
firms. Seventh, we conduct multiple falsification tests and find that our results only hold around the tariff
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cuts and not around any of the placebo events. Finally, following Heath, Ringgenberg, Samadi and
Werner (2021) we show it is unlikely that our results are either a false positive discovery or an artifact of
an invalid experimental design. Taken together all this evidence supports the validity of our tariff cuts
natural experiment in successfully identifying the causal effect of foreign competition on CEO risk-
incentive compensation.
To test how the increase in product market competition, brought about by heightened foreign entry,
affects managerial risk-taking incentives, we use a difference-in-differences methodology. Specifically,
we investigate how the convexity in CEO compensation measured by (1) the vega of the newly awarded
compensation contract (current vega) and (2) the vega of the newly awarded and all outstanding prior

4
Note, that the already sizable 10.11% increase in import penetration likely understates the true impact of the tariff cuts on
competition as a reduction in import tariffs also increases the threat of entry (Fresard and Valta (2016)).
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compensation contracts (total vega) is affected for treated firms relative to control firms using a two-year
event window around each tariff cut. We find that the increase in foreign competition leads to a 18.9%
lower total compensation vega and 42.1% lower current vega for treated firms relative to the control firms
around the event. These relationships are both statistically and economically significant. These results
suggest that an increase in competition leads to boards decreasing managers’ risk-incentive pay. 5
We also examine the channels through which foreign competition reduces CEO risk incentive-
pay. One possibility is a risk-based explanation: increased foreign competition increases the marginal
value of the manager’s existing risk-taking incentives which leads managers to voluntarily take on more
risk, and they therefore do not need to be incentivized with as much option pay. Another possibility is a
rent extraction explanation: increased competition disciplines managers and therefore reduces agency

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problems leading to these firms to reduce option pay. This rent extraction explanation assumes that

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treated firms, that may have weaker corporate governance pre-shock, have CEO compensation contracts
that are not structured optimally in the pre-event window. Consistent with the risk-based explanation, we

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find that firm risk increases following the tariff cuts, especially for firms with managers with higher
compensation vega. Meanwhile, inconsistent with the rent extraction explanation, we find that (1) there
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are not statistically significant differences in CEO total or cash pay in the pre-event period, (2) the
disciplining effect of competition does not change the CEO’s cash pay or pay-performance sensitivity and
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(3) empirical proxies for CEO empire building and quiet life behavior are not impacted by the increase in
competition. Taken together, these findings suggest that, at least in our experiment, the effect of the
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change in foreign competition on option compensation is more likely explained by a risk-based rather
than a rent extraction story.
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Finally, we find that our main result – that increased competition reduces CEO risk-incentive pay –
is stronger for firms with CEOs who are less risk-averse. We measure CEO risk aversion using CEOs’
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aircraft pilot certification as it has been shown in the psychology literature that individuals with pilot
licenses are likely to be less risk-averse (see e.g., Zuckerman (1971), (2007)). This evidence is
corroborated by evidence that CEOs who hold pilot licenses (hereafter: pilot CEOs) manage firms that
engage in more risk-taking behavior. For example, Cain and McKeon (2016) find that firms managed by
pilot CEOs have higher equity return volatility and leverage. An advantage of using this proxy for CEO
risk aversion is that CEOs’ choice of holding a pilot license is relatively exogenous and unlikely to be
affected by the time-variation in product market competition or executive compensation, especially in the
small windows around the tariffs cuts we study. The proxy is essentially able to capture a CEO’s time
5
These results are robust to (1) using several alternative matching specifications used to determine our control firms, (2)
regressing changes in risk-incentive pay on changes in import penetration (tariff cuts) around the event,(3) replacing Black-
Scholes vega with subjective vega to account for managerial risk aversion and under diversification, and (4) any confounding
effect due to CEO turnover.
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invariant risk aversion preferences. Unlike other empirical proxies of risk-aversion, CEO pilot license is
largely independent of time-varying firm or CEO characteristics that are the results of corporate policies
which in turn are influenced by the CEO’s risk aversion. Therefore, our proxy helps mitigate potential
endogeneity and measurement errors concerns that are common with other popular risk aversion proxies.
We find that less risk-averse CEOs (pilot CEOs) voluntarily take on more risk when faced with
increased foreign competition resulting in a larger reduction in risk incentive pay. In contrast, more risk-
averse CEOs (non-pilot CEOs) do not respond as aggressively to the intensifying foreign competition and
therefore do not experience large cuts in their risk-incentive pay. 6 To conclude, an exogenous increase in
competition brought about by increased foreign competition induces firms with less risk-averse CEOs to
adjust CEO option pay downwards to reduce CEOs’ risk-taking incentives. That is, the substitution

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between competition and risk-taking incentives is stronger for less risk-averse CEOs. This finding also

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lends support to the risk-based explanation for how changes in foreign competition affects risk-incentive
compensation.

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Our paper contributes to three branches of literature. First, we add to the broad literature that
studies the interplay between product market competition and corporate policies. Gaspar and Massa
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(2006), Hou and Robinson (2006) Irvine and Pontiff (2009), Hoberg and Phillips (2010) and Peress
(2010) study the implications of intensity of competition on firms’ cash flows and stock returns. MacKay
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and Phillips (2005) and Xu (2012) investigate how competition affects the quantity of debt. Valta (2012),
Fresard and Valta (2016), Akdogu and MacKay (2008) and Morellec, Nikolov and Zucchi (2014) explore
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how product market competition effects the pricing of debt, corporate investment, investment-q
sensitivity and cash holdings respectively. Dasgupta, Li and Wang (2018) examine how product market
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competition affects CEO turnover, while Hou and Robinson (2006) and Hoberg and Phillips (2010)
investigate how product market competition impacts the cost of equity.
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More specifically, our study contributes to the literature that explores the strategic interaction
between product market competition and CEO compensation. Cuñat and Guadalupe (2009b) study
deregulation in the banking sector in the 1990s and finds that the enhanced competition caused an
increase in pay-performance sensitivity of executives’ compensation contracts. Cuñat and Guadalupe
(2005, 2009a) use exogenous variations in competition induced by international trade shocks or foreign
exchange shocks to show that higher levels of competition increases the performance pay sensitivity of
executive compensation schemes in the UK and the US manufacturing sectors. 7 Karuna (2007) studies the

6
This finding is robust to measuring CEO risk aversion using CEO age as an alternative proxy.
7
Similar to our study, Cuñat and Guadalupe (2005), Valta (2012), Fresard and Valta (2016), Fresard (2010) and Dasgupta, Li and
Wang (2017) also focus on changes in product market competition induced by increased foreign entry. However, none of these
papers study how changes in foreign competition affect risk incentive pay.
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interplay between managerial incentives and various facets of product market competition and finds that
managerial incentives are positively related to product substitutability and market size, and negatively
related to entry costs. In contrast to these papers, we focus on how firms adjust managerial risk-incentive
compensation in response to increased product market competition induced by more intense foreign
competition.
More closely related to our work, Chen, Steiner and Whyte (2006) find that deregulation of the
US banking industry in the 90s coincides with an increase in option compensation in banks. Unlike our
paper, they do not identify a control group, and therefore the results may be an artifact of the increasing
trend of using options in the 90s (Murphy (1999)). Finally, in a recent study, Lie and Yang (2018) use
Chinese import shares in non-US high income countries as an instrument for product market competition

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to examine the effect of product market competition on executive compensation, including risk-incentive

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pay. In contrast, the tariff cuts experiment in this paper is likely to provide better identification, as it is
focused on sharp exogenous tariff cuts over a short period. We also show that the tariff cuts are unlikely

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to be a weak instrument as the tariff cuts significantly impacted product market competition due to a
considerable increase in foreign entry. Thus, our study provides compelling causal evidence on how
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changes in product market competition induced by more intense competition from foreign rivals affects
executives’ risk-taking incentives.
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The second branch of literature we contribute to is the empirical literature that finds evidence that
firms use option pay to adjust manager’s risk-taking activities and alleviate risk-related agency problems
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between managers and shareholders. Chava and Purnanandam (2010) and Bakke et al. (2016) find that in
response to exogenous reductions in CEO option pay, firms engage in less risk-taking activities. Gormley,
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Matsa and Milbourn (2013) find that in response to increases in firm risk, firms reduce option pay which
induces firms to engage in less risk-taking. We contribute by showing that firms respond to the
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intensification of the competitive environment by reducing the CEO’s risk-incentive compensation.

Third, our paper is also related to the theoretical literature on product market competition and
CEO compensation, in particular, how firms modify executive incentive contracts in response to changes
in competition (Hart (1983), Scharfstein (1988), Hermalin (1992), Schmidt (1997), Raith (2003)).
However, these studies do not provide predictions on the effect of competition on risk-incentive pay as
they consider linear contracts with no convexity and analyze the effect of intensified competition only on
managers’ pay-performance sensitivity (PPS).8 In contrast, we formulate and test hypotheses regarding
how boards adjust executive pay structures in response to exogenous changes in the firm’s competitive

8
Stoughton and Wong (2009) show that industry competition may play an important role in determining whether option or stock
compensation is optimal. However, they do not differentiate product market from labor market competition. In their model,
change in competition for talent in the labor market is the underlying reason firms choose different forms of compensation.
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environment that affect firm risk, potentially laying the groundwork for more rigorous theoretical work on
this topic in the future.9

2. Hypothesis Development

In this section, we discuss how product market competition interacts with managerial risk-taking
incentives. We describe the intuition of our analysis below and report a more comprehensive theoretical
model in the internet appendix.

Consider a firm that consists of shareholders and a manager. The latter influences the risk of the
firm through managerial decisions (e.g., how much effort and resources to spend on R&D activities, how

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aggressively to invest in new production technologies, etc.). A standard agency friction arises: managers
tend to have superior knowledge relative to shareholders about the allocation of effort and resources

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inside the firm as well as about the technologies available than the shareholders do. Therefore, the
manager’s risk choice is a private action that is not directly observable to the shareholders, who must

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design a compensation scheme that provides the proper incentives for the former to take on the optimal
amount of risk.
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If the manager and the shareholders have the same risk preferences, their optimal levels of risk
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would be perfectly aligned, resulting in a trivial compensation scheme. However, that is often not the case
in practice, because shareholders are usually much more diversified than the manager, whose wealth,
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career perspective, and reputation are much more closely tied to his performance at the firm. As a result,
managers are often more risk-averse than the average shareholder (Hall and Murphy (2002)), which can
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result in the manager making suboptimal risk choices. Risk-incentive compensation, such as the use of
stock options, are therefore necessary to align the risk preferences of the shareholders and the manager
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(Gormley et al. (2013) and Bakke et al. (2016)).

Risk-incentives compensation interacts with product market competition because the latter affects
the shareholders and manager’s risk preferences. Suppose the firm operates in an industry with several
competitors and can adopt either a safe business strategy or a risky one. The safe strategy guarantees the
firm’s survival, but the firm has to share the market equally with the competitors. The risky strategy either
asserts the firm’s dominance over its competitors and yields substantial profits if it succeeds, or bankrupts
the firm and forces it to exit the market if it fails. Now consider the effect of an exogenous escalation in

9
Our theoretical framework focuses on the effect of competition on risk-taking. However, notably enhanced competition can also
limit managerial agency problems (e.g., Hart (1983), Scharfstein (1988) and Hermalin (1992)) and in turn affect executive
compensation. This channel is likely to primarily affect compensation delta rather than vega because delta measures pay
performance sensitivity of the compensation contract which is aimed at mitigating agency problems and reducing managerial rent
extraction.
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competition, such as an increase in foreign entry. This dilutes the market shares of every market
participant, making the risky strategy more attractive because the payoff in the market-sharing scenario is
lower when the firm still plays safe. Put differently, because increased competition erodes profits and
lowers firm value, the cost of risk-taking, which is the loss of future profits if the risky strategy fails, is
lower. As a result, intensified competition increases the shareholders’ risk appetite. However, the same
effect occurs to the manager as well. If the manager is paid with options with values that are tied to the
firm performance, then the manager’s compensation is also lower when competition decreases firm value.
In the extreme case in which competition drives down firm profits and firm value to near zero, the
manager receives almost no compensation (from stocks or options) unless he adopts the risky technology
and succeeds. Consequently, the technology that was too risky for the manager before competition

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intensified becomes more attractive to him as well. In other words, the increase of competition also
increases the manager’ risk appetite, even without any adjustment to the manager’s compensation.

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The preceding argument, however, does not imply that the manager’s compensation should not be

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adjusted in response to changes in competition. In fact, while the risk appetite of the shareholders and the
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manager both increase following the increase in competition, it is theoretically unclear whose risk
appetite will increase more. If the risk appetite of the shareholders is more sensitive to the changes in
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competition than the manager, shareholders will prefer the mangers to take on more risk following an
increase in competition, and should consequently increase the manager’s risk-incentive compensation. If
the risk appetite of the shareholders is less sensitive to the changes in competition than the manager, the
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manger will voluntarily take on more risks than the shareholders desire following an increase in
competition, and the firm should consequently decrease the manager’s risk-incentive compensation. This
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leads to our first hypothesis:

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Hypothesis 1: Firms may increase or decrease managerial compensation contracts’ risk-taking incentives
in response to increased foreign competition

Whether competition and risk-incentive compensation should be substitutes or complements

depends on how sensitive the manager’s risk appetite is to the changes in competition. Therefore, the
manager’s degree of risk aversion is likely a major factor determining the relationship between
competition and risk-incentive compensation. In the internet appendix we develop a more comprehensive
model that implies the following testable hypothesis:

Hypothesis 2: Managerial risk aversion should affect the degree of adjustment in risk-taking incentive
pay in response to increased foreign competition
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Intuitively, the less risk-averse the manager is, the more risk the manager will voluntarily take on
when competition intensifies. As a result, the manager requires less risk-incentive compensation, and
competition and risk-incentive compensation are more likely to be substitutes. Conversely, the more risk-
averse the manager is, the less risk the manager will voluntarily take on when competition intensifies and
therefore the manager requires more risk-incentive compensation, implying that competition and risk-
incentive compensation are more likely to be complements.

Despite these theoretical predictions, empirical testing of these hypotheses requires careful design
and execution for at least two reasons. First, simply regressing CEO option pay against measures of
product market competition is insufficient for establishing a causal relationship due to endogeneity

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concerns. There is the possibility of reverse causality: how managers are compensated may affect how
aggressively they compete in the product market and, in turn, the degree of competition in the industry.

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There may also be unobservable industry-wide shocks that simultaneously affect both a manager’s
compensation and the intensity of product market competition in the firm’s industry. Second, there may

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be alternative hypotheses other than the mis-alignment of the manager and shareholders’ risk-preferences
that also affect the manager’s risk-incentive compensation. In particular, product market competition has
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generally been argued as an external governance mechanism. If the manager was entrenched and able to
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extract substantial rents from the shareholders, an intensified competition could help better discipline the
manager’s rent-extracting behaviors and therefore affect his entire compensation package. To overcome
these challenges, we exploit a quasi-natural experiment that identifies a source of exogenous variation in
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product market competition. We turn to this next, but first discuss how to empirically measure foreign
competition and managerial risk-taking incentives.
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3 Data
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Generally, firms provide risk taking incentives to managers by providing stock options as this
makes the manager’s expected compensation an increasing function of volatility. However, the risk-
taking incentives provided by stock option grants is multi-dimensional, as different characteristics of the
grant influence manager’s risk-taking incentives (e.g., the number of options granted, the strike price, the
vesting period, etc.). Therefore, to better measure risk-incentive compensation, we follow the literature
and measure managerial risk-taking incentives by CEO total compensation vega, which equals the change
in the CEO’s current and outstanding prior compensation in response to a 1% change in the volatility of
stock price (Coles, Daniel and Naveen (2006) and Core and Guay (1999), (2002)). Total compensation
vega which is primarily driven by options compensation, directly measures the sensitivity of the
manager’s compensation to volatility and it is sensitive to all option characteristics subject to annual
changes by the compensation committee. To alleviate concerns that arise from the skewness of vega, we
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measure vega as 𝐿𝑛(1 + 𝑣𝑒𝑔𝑎) in our analysis. Our results are unchanged if we replace 𝐿𝑛(1 + 𝑣𝑒𝑔𝑎 )
with 𝑣𝑒𝑔𝑎.
As total compensation vega includes the risk-taking incentives of outstanding option grants from
previous years, it may not allow detection of sudden changes in risk-incentive compensation (i.e., in
response to changes in the firm’s competitive environment). To verify that changes in CEO total
compensation vega are indeed due to options granted following the increase in competition, we
alternatively replace CEO total vega with CEO current compensation vega as our proxy for CEO risk
taking. Current compensation vega equals the change in the manager’s current (i.e., newly granted)
compensation in response to a 1% change in the volatility of stock price and therefore, unlike total
compensation vega, it is a flow variable. Thus, changes in current vega point out to changes in

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compensation policy in a specific year.

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We focus on foreign competition, measured as the degree of import penetration faced by US
firms. If import penetration increases, domestic firms face intensified competition in domestic product

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markets. Common problems with other standard measures of competition (such as Herfindahl indices and
price-cost margins) are that they are endogenous and difficult to measure or interpret systematically
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across firms over time, and that their levels are not necessarily indicative of the degree of competition
(Schmalensee 1989). Moreover, Herfindahl indices do not adequately capture foreign competition. For
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example, an industry’s Herfindahl index only accounts for domestic competition. Thus, the tariff cut
shocks, which represents an increase in foreign competition, would not be picked up by the Herfindahl
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index. In fact, it is possible that an industry’s Herfindahl index may increase (i.e., suggesting weaker
competition) following the tariff cuts as domestic producers exit the industry due to increased competitive
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pressure from abroad. Although it is theoretically possible to compile a Herfindahl index based on the
market shares of both domestic and foreign competitors, this is difficult in practice as detailed data on
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market shares for both foreign and domestic firms is not available for many industries.
Our data come from several sources. Compensation data is from ExecuComp. We use stock and
option holdings for CEOs and use this to estimate total and current vega following the methodology of
Core and Guay (2002). The total vega of each executive’s compensation is the sum of the vegas of all
outstanding options plus those of newly granted options which is used to calculate current vega. We
construct the import penetration and tariff variables following Bertrand (2004), Irvine and Pontiff (2009)
and Fresard and Valta (2016). Import penetration for each four-digit SIC industry is given by total value
of imports divided by the sum of total value of imports and domestic production (shipments minus total
exports). Tariffs in each industry are defined as the custom duties collected at U.S. Customs Service
divided by the custom value of imports at the four-digit SIC industry. Firm-level corporate variables are
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from Compustat. More details on the vega estimation procedure and all other variable definitions can be
found in Appendix A.

4 Tariff Cuts
In this section, we present our quasi-natural experiment which we use to empirically test the
predictions of the model.

4.1 Identification Strategy

Our identification strategy follows Fresard (2010) and Fresard and Valta (2016) and uses sharp
cuts in import tariffs as shocks to product market competition. 10 As our detailed executive compensation
data start in 1993, we focus on tariff cuts in 1995, 1997 and 1998. Most of these tariff cuts occurred in

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1995 (two-thirds of our sample), stemming from the implementation of the North American Free Trade

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Agreement (NAFTA) as well as the ratification of the global Uruguay round in mid-1994. NAFTA, which
eliminated tariffs on more than 50% of US imports from Mexico and significantly eased Mexican firms’

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access to the US markets.11 As a result of the conclusion of the Uruguay round the US reduced tariffs by
on average 35%. These tariff cuts were implemented gradually in 1995 and after. 12 In addition, the 1997
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and 1998 tariff cuts were largely the result of the 1997 International Technology Agreement (ITA) – an
offshoot of the Uruguay round – which reduced tariffs on high technology products (Feenstra, Mandel,
lP

Reinsdort and Slaughter (2013)).

Following the tariff cuts, domestic firms faced higher product market competition as more foreign
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firms entered the market and import penetration increased. Moreover, the threat of more foreign firms
entering the market also increased competitive pressures on domestic firms.13 Bolstering the case that the
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tariff cuts were seen as a source of increased competition, Fresard and Valta (2016) show, using textual
analysis of Management’s Discussion and Analysis (MD&A) section of firms’10-Ks, that firms in
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industries that experienced tariff cuts (i.e., treated firms) recognized the increased competitive threat

10
Sharp tariff cuts are defined as specific tariff reductions in an industry-year when the negative change in the tariffs is at least
three times larger than the industry's average change. This is a similar criterion compared to those used in other studies such as
Fresard and Valta (2016) and Dasgupta et al. (2018)).
11
NAFTA was a multinational deal between Canada, the US and Mexico, but most of the tariff reductions between the US and
Canada had already been completed when a free trade agreement between the two countries was signed and implemented in 1987
and 1989 respectively.
12
The Uruguay round of trade negotiations between 117 countries lasted seven years. A consensus was reached at the end of
1993 and the agreement signed in mid-1994. Tariff cuts (as well as the elimination of other trade barriers) were deep, broad and
widespread. Other industrialized countries made tariff cuts of similar magnitudes as the US (reductions of about 40% on
average). The Uruguay round was ratified by both chambers of Congress in late Fall 1994 and signed into law in December 1994.
13
The 1994-1995 Mexican peso crisis would have further increased the competitive pressure on US firms due to the stronger
dollar/weaker peso which would make Mexican exports more competitive. However, the depreciating peso exerts competitive
pressure on all industries (treated as well as control). Assuming treated and control industries are similarly affected, the effect of
the Mexican peso crisis on risk-incentive pay should difference out in the DID analysis.
 Journal Pre-proof

brought about by the 1997 and 1998 tariff cuts more than control firms.14
It is common for firms to lobby for or against regulatory change – and such lobbying activity may
be correlated with outcome variables. The trade literature has indicated that such political economy issues
are particularly problematic with regard to tariff cuts (see, e.g., Hillman (1982), Mayer (1984), Magee,
Brock, and Young (1989), Bohara and Kaempfer (1991) and Trefler (1993)). Despite this there are several
reasons why these concerns are less troubling in our setting. First, it is unlikely that firms in industries in
which tariffs were cut lobbied in favor of tariffs cuts. In contrast, these firms are more likely to have
lobbied in favor of continued protection making it less likely that they were able to influence the timing or
nature of the tariff cuts.15
Second, as argued in Krugman, Obstfeld and Melitz (2015), firms are less likely to be able to

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influence the terms of large multi-national trade deals such as NAFTA or the Uruguay round. The logic is

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that in multilateral trade negotiations exporters stand to gain from a liberalization of trade between the
involved countries and therefore provide an effective counterweight to lobbying by import-competing

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producers. In contrast, unilateral tariff cuts (such as those that comprise the majority of the tariff cuts
studied in for example, Dasgupta et al. (2018)) are likely to be effectively opposed by domestic
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producers, who stand to lose from a tariff reduction and are typically better informed and organized than
the domestic consumers that stand to gain. In sum, focusing on tariff cuts resulting from multinational
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trade deals helps allay concerns that the interaction between firms and politicians determine the terms of
these treaties which makes it less likely that political economy concerns are biasing our results.
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Another nice feature of the tariff cuts experiment is that, consistent with prior studies (e.g.,
Fresard (2010), Valta (2012) and Fresard and Valta (2016)), the evidence suggests that the nature and
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extent of the tariff cuts were largely unanticipated. There was significant uncertainty regarding whether
NAFTA would pass in late 1993 right up to the contentious vote in the House on November 17, 1993.
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Moreover, the final outcome of the protracted Uruguay round was not settled until a consensus among all
nations was reached in late-1993.16 These reasons make it less likely that our findings are contaminated

14
This analysis is in Table 3 of a 2014 working paper version of Fresard and Valta (2016) but was taken out of the published
version of the paper.
15
It is possible that firms lobbied against the reduction in tariffs (i.e., politically connected firms may have attempted to end up in
the control group). However, the control group already had very low tariffs on average (see Figure 1 Panel A) which makes this
less likely. Another possibility is that firms that had stronger competitive positions, were more likely to benefit from outsourcing
or were better positioned to take advantage of improved export opportunities may have lobbied in favor of tariff cuts in their
industries. However, there is little evidence that firms actively lobby in favor of tariff reductions.
16
The negotiations stretched for slightly more than seven years. Numerous times the negotiations stalled or broke down entirely.
Even in mid-1993 there existed significant uncertainty regarding if, when and what would come out of the Uruguay round as
suggested in the New York Times at the time: “But finalizing the deal won't be easy. Mr. Clinton will have to overcome
opposition from the domestic textile industry and the French Government, which threatens to undermine the entire agreement for
the sake of a handful of farmers.”
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by firms adjusting option pay in anticipation of the ratification of these major trade deals. 17
In our empirical design, we exploit the fact that these free trade agreements (hereafter collectively
referred to as: FTAs) led to large tariff cuts in some industries, but left tariffs largely unchanged in others.
That is, we compare the effect of the FTA-induced increases in competition in industries that experienced
sharp cuts in tariffs (treated firms) to control firms in industries that were largely unaffected by the
passage of the FTAs. To implement this test we use a difference-in-differences (DID) methodology. More
formally, we estimate the following DID specification:

𝑌𝑖𝑡 = 𝛼 + 𝛽𝑑𝑡 + 𝜔𝑇𝑖 + 𝜂𝑑𝑡 𝑇𝑖 + 𝑧𝑖𝑡 𝛿 + 𝜀𝑖𝑡 . (1)

Here, 𝑌𝑖𝑡 is the outcome variable: total vega or current vega of firm i at time t. 𝑑𝑡 is an event dummy that

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equals one after the tariff cut and zero before. 𝑧𝑖𝑡 is a vector of controls that contains factors affecting 𝑌𝑖𝑡
that may have changed around the event. 𝑇𝑖 is an indicator variable that equals one if the firm is in the

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treated group and zero otherwise. The coefficient on the interaction term 𝜂 gives the DID estimate of the

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effect of the tariff cuts on risk-incentive pay measured by vega, 𝑌𝑖𝑡 . The unbiased estimation of 𝜂 will not
be compromised by trends that commonly affect both the treated and control groups. On the other hand,
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trends that differentially affect the treated and control groups can introduce bias in 𝜂 (i.e., this represents a
violation of the parallel trends assumption). For instance, our estimation of 𝜂 would be biased if treated
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firms receive an unobservable productivity shock that coincides with the tariff cuts and leads to changes
in CEO risk-incentive pay.
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We estimate (1) using a four-year event window around each tariff cut in which the pre-shock
period includes the two years preceding the shock and the post-shock period includes the two years
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following the shock. The use of a short window strengthens the internal validity of our empirical strategy
as it makes it less likely that other determinants of managerial risk-taking incentives changed
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differentially for treated and control firms during the event window. It is also important to note that the
short window should be sufficient to capture the effect of an FTA-induced increase in product market
competition on option pay because compensation contracts, when used to alleviate risk-related agency
problems, are likely adjusted within two years of the sharp drop in tariffs.
Tariff shocks in the 1990’s could affect firms differentially if they have different financing
policies, growth options and investment opportunity sets. To further guard against the presence of
potential sources of differential trends such as these, we follow Fresard and Valta (2016) and use
matching estimators. That is, we use propensity score matching to match each firm in the treated group to

17
It can be argued that it is more likely that the 1997 and 1998 tariff cuts were anticipated as they are further removed from the
passage of NAFTA in late 1993. Thus, it is comforting to note that the main results, although slightly weaker in statistical
significance, remain robust to only looking at the 1995 tariff cuts. The weaker results could potentially be due to statistical power
issues as we lose 1/3 of the sample as only 76 treated firms remain in the sample.
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a firm that is unaffected by the tariff cuts but that is otherwise similar, based on pre-treatment firm level
characteristics that are widely recognized in the literature as being important determinants of managerial
risk-incentive pay (e.g., see Core and Guay (1999) and Coles et al. (2006)). Specifically we use market-
to-book, cash ratio, size, leverage, cash flow volatility, capital expenditure, and firm risk (measured by
the log of daily stock return volatility) as our matching variables. As the tariff cuts occur in three separate
years (1995, 1997 and 1998), treated firms in one year are excluded from being control firms in the other
years. As all the treated firms are manufacturing firms, our matching specification restricts the control
sample to manufacturing firms (with SIC codes between 2000 and 4000). Matching in the main tests is
done with replacement. Our empirical methodology in (1) is akin to a stacked DID methodology as we
focus only on two years around each tariff cut and exclude any treated firms from subsequently being

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used as a control firm. Therefore, our empirical setup is not subject to the critique of staggered DID

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methodologies in Baker, Larcker and Wang (2022).
Table 1 Panel C presents the summary statistics (means and medians) for the treated and control

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firms in the pre-shock period. After matching, the treated and control samples are statistically different
only in the mean of size and book leverage (each only at the 10-percent level). In addition, treated firms
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have higher average total and current vegas in the pre-shock periods, but the differences in medians are
not statistically significant. The differences in the medians of all other firm and CEO characteristics are
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not statistically significant. Thus, overall the evidence suggest that the treated and control firms are rather
similar along observable firm characteristics. This is comforting as it reduces the likelihood of any
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unobservable trends that may bias our estimation. We provide further evidence for why the parallel trends
assumption is likely to hold in our setting in section 4.6.
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To verify whether in our sample the tariff cuts constitute a significant shock to product market
competition, we plot average industry import penetration and tariff levels for treated and control firms
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using a two-year window on each side of the tariff cuts (see Figure 1). When taking the average, the value
for each industry is weighted by the ratio of treated or control firms in that industry to the total number of
treated or control firms (in that year).

We observe that whereas tariffs drop sharply for the treated firms (from 3.5% to 1%), they do not
change for control firms. Moreover, competition, proxied by import penetration, increases about 10%
more for treated firms relative to control firms around the tariff cuts. 18 Below we argue that this is
meaningful and significant. First, a 10% relative change seems economically meaningful especially given
that import penetration is relatively slow moving. Entering a product market and achieving a meaningful
market share (especially in a foreign country) takes time. Second, a 10% relative decline may

18
The difference in import penetration between treated and control firms falls from 0.125 to 0.11 translating into a 10% relative
increase in import penetration.
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underestimate the competitive impact of the tariff changes as tariff cuts also increase the threat of entry.
For instance, as it is now easier for foreign firms to enter the market, domestic firms face more
competition even absent foreign firms actually entering the market. Third, other studies (e.g., Valta,
(2012), Flammer (2015), Fresard and Valta (2016), Dasgupta et al. (2018), Huang et.al (2017)) that
employ similar tariff cuts to the ones we use find a similar magnitude of changes in tariffs and import
penetration and argue this constitutes a significant shock to foreign competition. 19 The average tariff cut
in our sample is 2.5% - a 71% reduction relative to the pre-shock average tariffs - which is larger than the
average tariff cuts in other studies that include a longer period. For example, Valta and Fresard (2016)
include tariff cuts from 1972 and 2005 and have an average tariff cut of 2% - a 44.4% reduction relative
to the pre-shock average tariffs. The larger impact of the tariff cuts on foreign competition in our study is

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likely because we focus on tariff cuts resulting from major trade deals in 1990s such as NAFTA.

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Finally, to further illustrate that these changes in tariffs and import penetration in our study are
meaningful, we use a dynamic leads-and-lags model (e.g., Autor (2003), Atanasov and Black (2016)

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Jeffers (2019) and Xu and Kim (2021)) to infer whether the gaps in tariffs or in import penetration
between the treated and control firms each year are statistically different from the gap in year -2 (the
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omitted benchmark in the model). Figure 2 plots coefficient estimates with 95% confidence intervals from
the following dynamic specifications of the DID analysis:
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𝑌𝑖,𝑡 = 𝛼 + ∑𝑡+1 𝑡+1

𝑗=𝑡−1 𝛽𝑗 ∙ 𝑇𝑖 × 1[𝑌𝑒𝑎𝑟 = 𝑗] + ∑𝑗=𝑡−1 𝜃𝑗 ∙× 1[𝑌𝑒𝑎𝑟 = 𝑗] + 𝜀𝑖,𝑡 . (2)
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The dependent variable (Yit ) is average tariffs (Panel A) and average import penetration (Panel
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B) in the three-year window around the treatment year (year = 0). The coefficient 𝛽𝑗 represents the
treatment effect: the difference in Y between the treated and control observations in year j, where j takes
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value t – 1 (one-year before treatment), t (treatment year), and t + 1 (one-year after treatment). The
omitted year, and thus the benchmark, is year t-2. In Figure 2 we plot the coefficient estimates βj from
the dynamic difference-in-difference specification in (2) of difference between tariffs and import
penetration for treated and control firms around the tariff cuts. Both graphs in Figure 2 show that the
difference between the treated and control groups is not statistically different in year -1, but statistically
smaller in year 0 and 1 (i.e., in the post-shock period). This analysis suggests the treated and the control
groups are similar in changes in tariffs and changes in import penetration in the pre-event period.
19
Many of these studies focus on longer time periods and therefore include more tariff cut events. In contrast to these studies, we
are constrained by Execucomp which only reports compensation data for S&P1500 firms starting in 1992 data. We also exclude
tariff cuts in the early and mid-2000s due to FAS 123R, which caused major changes in option compensation that, could
potentially confound our analysis. How we define what constitutes a significant tariff cut is similar to these other studies. In other
words, the difference in which tariff cuts are included in our study is due to our shorter time period and not how we define a
significant tariff cut.
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However, they experience statistically different changes in both tariffs and import penetration following
the event. These results further validate our DID setting by demonstrating that the tariff cuts lead to
significant reductions in tariffs and significant increases in foreign competition. In sum, the discussion in
the preceding paragraphs suggests that the 1995, 1997 and 1998 tariff cuts constitute a meaningful source
of plausibly exogenous variation in foreign entry and therefore in product market competition (i.e., the
tariff cuts are unlikely to be a weak instrument).
4.2 Main Results
To test how CEO risk-taking incentives are affected by the increased product market competition
induced by intensified foreign entry, we present the results from our difference-in-difference regressions
in Table 2. The coefficient of interest (the interaction term, 𝜂 in equation (1)) is negative and statistically

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significant in all specifications. Overall, these results suggest that for an average firm in our sample, an

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increase in foreign competition leads to boards decreasing managers’ risk-taking incentive pay. In terms
of economic significance, we find that the increase in foreign competition leads to on average 18.9%

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lower total compensation vega and 42.1% lower current compensation vega for treated firms relative to
the control firms around the event window. Thus, the negative affect of competition on risk-taking
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incentives is both statistically and economically significant. 20
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These results are robust to including a rich set of control variables including total assets, market-
to-book ratio, book leverage, cash flow volatility, capital expenditure, cash, firm age, firm risk, CEO
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compensation delta and export-to-sales ratio. CEO compensation delta is included as a control variable in
our regressions as enhanced competition can help mitigate managerial agency problems (e.g., Hart, 1983;
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Scharfstein, 1988, Hermalin, 1992) which in turn may lead to the board primarily decreasing the delta of
CEO compensation contract rather than changing the compensation vega. Thus, controlling for CEO delta
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can help better isolate the effect of foreign competition on risk-based incentives (vega).
Our main results are robust to several alternative matching specifications used to determine our
control firms. First, we extend the matching sample to allow non-manufacturing firms. Second, for each
event, we no longer allow matching with replacement. That is, for the same event (i.e., for each year of
tariff cuts), no two treated firms have a common matched firm; two treated firms associated with different
events, however, may have the same matched firm. Third, we use different sets of matching variables.

20
To the extent that previously granted options were issued at the money, and increased competition pushed them further away
from being at the money, this would lead to declines in Vega of previously awarded options. However, this mechanical drop in
vega does not pose a threat to the internal validity of the experiment. Why? If vega decreases mechanically, holding everything
else constant, the CEO’s risk-taking incentives are lower. If board wants the CEO to maintain the same level of risk as before,
then it will increase the number of options granted to the CEO to make up for the decrease in vega. Therefore, as long as vega
can be adjusted in response to the increase in competition, the fact that vega decreased after the tariff cuts still suggests that risk-
taking incentives from the contract is lower. That is, the board found it optimal not to make up for the competition-induced
mechanical drop in vega of previously awarded options.
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The results are qualitatively similar in each case.

In addition to our main specification, which uses the discrete version of the treatment, we also as
a robustness test employ the continuous version of import penetration and tariffs. Specifically, we regress
changes in total vega (current vega) on changes in tariffs (import penetration) around the event. Changes
are calculated as the change in the averages in the two-year pre-shock window and the two-year post-
shock window. The results are reported in Table 3. It is comforting that the coefficients on changes in
tariffs and changes in import penetration remain statistically and economically significant and are
consistent with our main findings reported in Table 2.
4.3 CEO Subjective Compensation Vega
We consider the possibility that the Black-Scholes vega that we use in our main tests may not

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perfectly capture the risk-preferences of risk-averse managers (Ingersoll (2006)). This is because CEO

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risk aversion and the inability of the CEO to trade his firm’s stocks and options in the market (resulting in
CEO under-diversification) are ignored in Black-Scholes vega. Thus, as an alternative measure to Black-

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Scholes vega, we use a certainty equivalent approach to estimate the CEO risk-incentive compensation. 21
The alternative measure, CEO subjective compensation total vega, is estimated as the change in
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the certainty equivalent of the CEOs’ option holdings by changing the volatility of the stock returns by
1%. To estimate CEO subjective compensation vega we follow the methodology in Ingersoll (2006) using
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the code made available by Peters and Wagner (2014) – we use the same parameter choices as Peters and
Wagner (2014): risk-aversion coefficient = 3, and portfolio constraint = 50%. This estimate of CEO risk-
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incentives has the benefit of incorporating both the CEO’s risk aversion and his portfolio under-
diversification. Due to the skewness evident in CEO subjective vega, we run our tests using Ln(1+
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subjective vega) as the dependent variable. We use both total and current CEO subjective vega.
In these tests reported in Table 4, we substitute CEO vega with CEO subjective vega and run
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similar specifications as those in Table 2 in the paper. We find that our main results are unchanged, i.e.,
the coefficient on the interaction term (Treated x Shock) is negative and statistically significant in all
specifications which is consistent with our findings using Black-Scholes vega in Table 2. This means that
for our alternate measure of risk-incentive compensation (subjective vega), we find that CEO risk-
incentives drop more for the treated firms relative to the control firms after the increase in foreign
competition.

4.4 CEO Turnover and Tariff Cuts

There are cases of CEO turnover during our sample which may lead to a few concerns. First,

21
Other studies that estimate compensation vega using a certainty equivalent approach are Lambert, Larcker and Verrecchia
(1991), Lewellen (2006), Chava and Purnanandam (2010) and Hall and Murphy (2002).
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hiring a new CEO may have important effects on CEO compensation packages that are unrelated to
changes in product market competition. For example, relative to the old CEO, the new CEO may have
different unobservable traits such as higher or lower risk aversion that can explain the changes in the
optimal risk-incentive pay which we attribute to our shock to foreign competition. Similarly, CEO
turnover may be indicative of significant time variation in firm or industry characteristics unrelated to
tariff cuts (such as changes in investment opportunities or financial constraints) that could affect risk-
incentive pay independently of the tariff cuts. Finally, there are reporting concerns when the new CEO
takes office midway through the fiscal year.
We conduct the following analyses to alleviate these concerns. First, in our main specifications in
Table 2, we exclude firms with a new CEO in the immediate year after the shock. Second, in Table D.1 in

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the Internet Appendix we drop all firms that hired a new CEO in any year during the event window (pre-

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or post-) and repeat all the tests. There are 57 firms with CEO turnovers in our sample. We find that our
results, although somewhat weaker in statistical significance (perhaps due to a smaller sample and less

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statistical power), remain qualitatively similar. Finally, in Table D.2 in the Internet Appendix we
investigate whether CEO turnover is affected by the tariff cuts. To this end, we use CEO turnover as the
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dependent variable in a specification similar to our DID specification in Table 2. The coefficient on the
DID interaction term is not statistically significant suggesting that CEO turnover does not change
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differentially for the treated firms relative to control firms around the change in tariffs. 22 In summary,
these tests indicate that it is unlikely that our results are an artifact of CEO turnover.
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4.5 Exports and Tariff Cuts

Tariff cuts may not only intensify foreign competition in the domestic product market, but may
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also be a boon to exporters. In other words, exporters may be less adversely affected by the shock than
importers. This is especially the case if the tariff cuts are accompanied by reciprocity on the behalf of
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foreign trading partners which was certainly the case in some US industries as a result of the passage of
NAFTA and the conclusion of the Uruguay round of trade agreements. This positive shock to exporters
may undermine the validity of our experiment.
To mitigate this issue, we perform several tests. First, we compare the exports/sales ratio of
treated and control firms in the pre-treatment period and find that treated and control firms are similar
along this dimension, making it less likely that any positive shocks to exports would lead to violations of

22
Although at first glance this seems to be in contrast with the results reported in Dasgupta et al. (2018), who find that tariff cuts
increase the likelihood of forced CEO turnover, there are important difference between our tests and theirs. They focus on only
forced CEO turnovers while we consider all turnovers. In their sample about 16% of CEOs turnover each year, however, forced
turnovers account for only slightly more than a quarter of these. In addition, their sample includes a significantly longer time
series (1974-2005) than our study.
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the parallel trends assumption.23 Second, we include the firm’s exports as a control variable in the DID
regressions. The results remain unchanged. Third, we drop all firms that export from our analysis and
redo our tests. The results are qualitatively similar although sometimes weaker in terms of statistical
significance (likely due to a smaller sample size). Fourth, in Table 5 we also directly investigate whether
there is a differential change in exports following the reductions in the tariffs. We replicate our main DID
specification from Table 2 but replace the dependent variable with export-to-sales ratio. We find that the
DID coefficient is not statistically significant, suggesting that the exports of the treated and control firm
did not change differentially following the reduction in the tariffs.24 Overall, this battery of tests makes it
less likely that our main results are artifact of the free trade agreements boosting exporters or affecting the
exports of the treated firms differentially from those of control firms. 25

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These tariff cuts also coincide with the appreciation of the US dollar relative to the Mexican peso
and Canadian dollar. To the extent that exporters are more likely to be affected by these exchange rate

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changes, it is important to tease out the effect of enhanced competition over and above these other factors
and guard against any potential differential effect due to these changes. Because we find the treated and
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control firms are similar along exports/sales ratio in the pre-treatment period and that we include the
firm’s exports as a control variable in our analysis, it is less likely that this potential confounding factor
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biases our findings.

4.6 Lobbying and Supply Chains

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Another concern, as discussed previously, is that tariff cuts are endogenous as firms lobby for
protection. In an attempt to further assuage these concerns, we repeat our tests restricting the sample to
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only tariff cuts in 1995 as these tariff cuts occur shortly after and were the direct result of the passage of
the FTAs; Krugman et al. (2015) find that lobbying is less likely to influence the terms of large multi-
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national trade deals such as NAFTA or the Uruguay round. We find that all the coefficients retain the
same sign and remain statistically significant although sometimes at a lower level (likely due to a 40%
smaller sample). It is comforting that our results continue to hold for the tariff cuts that are least likely to

23
We find similar results if we replace the continuous exports/sales ratio with a dummy variable that equals one if the firm
exports and zero otherwise.
24
We acknowledge that the lack of availability of detailed data on exports does not allow us to focus on exports to only Mexico.
That being said, given that variation in Mexican exports is likely a significant part of the variation in overall exports around the
tariff cut, it is comforting that the change in the overall exports of the treated and control firms did not differ following the tariff
cuts.
25
One concern is that US firms can offshore production to other countries following the implementation of the FTAs. For
instance, US firms can set up production facilities in Mexico or readjust their supply chains to incorporate cheaper Mexican
inputs. This became easier and more profitable after the passage of NAFTA. However, it would take some time to change supply
chains and/or move production facilities making it less likely that this would confound our results in the short window around the
FTAs that we utilize in our tests. Nonetheless, firms with existing supply chains or existing production facilities outside the US
would benefit more from the tariff cuts. To the extent that treated and control firms differ along these dimensions, this could
affect our results.
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be affected by lobbying.
Another important issue is that free trade agreements may create a spillover effect on vertically
integrated industries. For example, a reduction in import duty for automotive parts, which results in
intensified competition in that industry, may be a positive shock for automobile manufacturing industry
due to lower prices and/or increased availability of higher quality auto parts. This spillover effect to other
industries means that it is possible that control firms were also affected by the increase in competition
within the supply chain. To address the concern that these spillovers could potentially undermine the
validity of our experiment, we conduct the following exercise. We obtain detailed supply chain data that
indicate the immediate customers and immediate suppliers of firms included in the S&P 1500.26 Using
these data we identify all of the matched control firms that are immediate customers or suppliers of the

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treated firms in our sample. We find only four pairs of treated-control firms in our analysis that are

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directly linked within their supply chain - directly linked means one firm is either a direct supplier or a
customer of the other. Because there are so few pairs of treated-control firms in our analysis with the

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potential of direct vertical spillover effects, we drop these four pairs from our analysis and repeat our
main specifications in Table 2. In this additional analysis, presented in Internet Appendix Table D.3, our
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findings remain qualitatively and quantitatively similar which indicates that vertical spillovers are
unlikely to be driving our results. Moreover, these findings also corroborate the validity of the assumption
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that control firms are less likely to be affected by the tariff cuts, implying that it is less likely that the
Stable Unit Treatment Values Assumption (SUTVA) in our DID experiment is violated.
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4.7 Parallel Trends Assumption and Placebo Tests

As previously discussed in section 4.1, the key identifying assumption underlying the DID
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technique is that both treated and control firms should experience parallel trends in the outcome variable
in the absence of treatment. This means that if tariff cuts did not occur the DID coefficient should be zero.
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Although this assumption of parallel trends cannot be directly tested, we perform a variety of tests
suggested by Roberts and Whited (2013) to assess if the parallel trends assumption is likely to hold in our
setting.
First, we investigate trends in the outcome variables prior to the tariff cuts. In Figure 3 we plot the
trends in CEO total and current compensation vega around the tariff cuts. In regard to both CEO total and
current compensation vega, treated and control firms display reasonably parallel trends in the pre-
treatment period. That being said, there is a visible difference in the CEO current vega trends between the

26
We would like to thank Xiaofei Zhao for sharing the supply chain data which is originally used in Cen, Danesh, Ornthanalai
and Zhao (2021).
 Journal Pre-proof

treated and control groups from year 1 to year 2. To better evaluate whether treated and control firms
experience parallel trends in the outcome variables in the pre-treatment period we test the same dynamic
leads-and-lags model as that used in Section 4.1. using current and total vega as the dependent variables.
Figure 4 plots the estimated coefficients βj (j = t – 1, 0, and t + 1) as well as the 95% confidence interval.
In both panels, the 95% confidence interval for βt−1 includes 0, indicating that βt−1 is statistically
insignificant. In other words, while the gap between the treated and control observations in year -1 is
smaller (βt−1 < 0) than that in year -2 (the benchmark year), this difference is not statistically significant.
Thus, prior to the tariff cuts, the estimated difference between the treatment and control groups is
statistically indistinguishable from zero which is supportive of the parallel trends assumption. The tariff
cuts induce treated firms to increase vegas at significantly lower rates than control firms.

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It is important to point out that there exists a positive trend in CEO risk-taking incentives (i.e.,

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total and compensation vega) during our sample period which is consistent with the increase in the use of
option compensation during the 1990s. Seminal papers such as Murphy (1999) and Murphy (2013) have

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for example, documented this positive trend. This positive trend in compensation vega continues until
2005 when the implementation of FAS 123R lead to a decrease in option compensation. The use of the
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control group in our difference-in-differences (DID) analysis is to control for this trend. To the extent that
the control firms are unaffected by the shock to foreign competition, such trends to option compensation
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and vega would be differenced out.

Therefore, although it seems compensation vega for the treated firms did not decrease following
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the tariff cuts, they do decrease relative to the control firms’ compensation vega which follow the
increasing trend during the 1990s. Our evidence suggests that the unchanged vega of the treated firms in
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our Figure 3 (relatively flat from pre- to post- event period) is due to the negative treatment effect caused
by the reduction in tariffs among the treated firms. That is, in the absence of the treatment (i.e., the shock
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to foreign competition), the treated firms would likely have also exhibited a positive trend in
compensation vega. Most of the effect of the intensifying foreign competition on treated firms’ risk-
taking incentives seems to be concentrated in the year of the tariff cut, indicating that firms change
managers’ compensation vega in anticipation of increased future competition (i.e., the threat of
heightened foreign entry).
Second, we compare firm and CEO characteristics of the treated and control firms in the pre-
treatment period to make sure that prior to the tariff cuts the two groups are similar. As shown in Panel C
of Table 1, treated and matched control groups are indeed similar as we find only a few statistically
significant differences between the means of the observable characteristics of the two groups. The
differences in medians of firm characteristics are all statistically insignificant. The overall similarity in
observable firm and CEO characteristics, which is in support of the parallel trends assumption, is
 Journal Pre-proof

reassuring because it makes it less likely that unobserved differences between the groups are driving our
results.
Third, to better assess that our results are unique to the tariff cuts, we perform several placebo
(falsification) tests in which we falsely assume a treatment occurs. More specifically, we repeat the
baseline experiment during time periods in which the tariff cuts did not occur. For both placebo
experiments, we use the years 2001, 2003 and 2004 as placebo shock years instead of 1995, 1997 and
1998. The treated firms are the same as in our main tests in section 4.2 and are assigned to placebo years
chronologically according to when the firm was treated. For example, firms that were treated in 1995 are
assigned to 2001; firms that were treated in 1997 are assigned to 2003 etc. For the first placebo
experiment, we also keep all the control firms the same, but in the second placebo experiment we define

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control firms as firms that are propensity score matched using the same matching variables as our main

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exercise in the placebo pre-event period. That is, the first placebo experiment keeps both treated and
control firms the same while the second has the same treated firms, but new control firms found by

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applying the same matching methodology as in our main tests to the pre-placebo data instead.
We then examine the change in total and current vega around the false shocks by running our
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baseline DID regressions. Table 6 outlines the results of these falsification tests. The estimated treatment
effect is statistically insignificant in both experiments. This means that changes in CEO total and current
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compensation vega are similar for treated and control groups in the placebo periods. These findings
support our main results that the changes in CEO risk-incentive compensation likely stem from changes
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in import penetration resulting from the tariff cuts. In sum, these placebo tests indicate that the treated and
control firms tend to exhibit similar trends in CEO risk incentive-pay outside of the tight window around
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the tariff cuts making it more likely that the parallel trends assumption is valid in this setting.
In addition, in Appendix B, we follow Heath, Ringgenberg, Samadi and Werner (2021) and show
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it is unlikely that our results are either a false positive discovery or an artifact of an invalid experimental
design.

5 How Does Foreign Competition Affect CEO Risk Incentive-pay?

In our analysis we find evidence that firms respond to increases in foreign competition by
reducing CEO risk-incentive pay. What are the channels through which foreign competition affects CEO
risk incentive-pay? One channel that can explain our empirical results is a risk-based story. Here the
increased foreign competition increases the marginal value of the manager’s existing risk-taking
incentives leading to the manager voluntarily taking on more risk, and the manager therefore does not
need to be incentivized with as much option pay. Another potential channel is a rent extraction
 Journal Pre-proof

explanation. Increased competition disciplines managers and therefore makes rent extraction by managers
less likely. Improved corporate governance at firms that face more competitive pressure leads to these
firms reducing option pay to make their pay structure optimal. This rent extraction explanation assumes
that treated firms have weaker corporate governance pre-shock, and that these firms have CEO
compensation contracts that are not structured optimally in the pre-event window. In this section we
examine the evidence for each channel.
We begin with exploring the rent extraction channel. This story relies on the argument that
managers prefer higher levels of option pay and consequently would, in the absence of competitive
pressure, influence their own compensation contracts in the direction of higher option compensation. By
this rationale if treated firms in the pre-shock period have lower levels of corporate governance (perhaps

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due to less competition) this could explain why they may have too much option pay. However, this

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argument runs contrary to the fact that managers, due to their wealth and human capital being tied to their
firm, are more risk-averse than shareholders and would not prefer excess levels of option pay. In fact,

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managers would require an increase in total pay to compensate them for any extra option pay (i.e., to
compensate them for the higher risk premium in their contract), and if managers, in the absence of
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competitive pressure, could set the terms of their own compensation contracts, one would expect to see
higher level of cash pay in the pre-event window as risk-averse managers prefer certain cash
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compensation. We find empirical evidence that is inconsistent with both rent extraction predictions.
Inconsistent with the former we find no difference in the average total compensation between the treated
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and control firms in the pre-event window (see Panel C of Table 1). Inconsistent with the latter we do not
find statistically significant differences in average cash compensation between the treated and control
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firms in the pre-event period (see Panel C of Table 1).

To build on this, we also investigate if the shock to foreign competition reduces CEO cash
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compensation. If our findings are due to the disciplinary effect of competition, we would expect increased
competitive pressure to reduce cash compensation as managers are no longer able to inflate their own
cash compensation. To test this, we replace the dependent variable with CEO cash compensation in our
main specification from Table 2. We do not find a statistically significant effect of foreign competition on
cash compensation which is inconsistent with the alternative rent extraction explanation (see Table 7).
Second, if enhanced foreign competition has a disciplinary effect on managers and acts as
substitute or a complement in aligning the interest of the CEO with those of the shareholder, we would
expect to find meaningful changes in CEO compensation delta, which measures the pay-performance
sensitivity of the CEO’s compensation contract, following the shock to competition. To investigate this
further, we replace the dependent variable in our main specifications in Table 2 with CEO delta.
However, inconsistent with the rent extraction explanation we do not find a statistically significant effect
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on CEO delta in our sample (see Table 7).

A third piece of evidence that is inconsistent with the rent extraction explanation is that we find
little evidence that enhanced foreign competition, through its potential disciplinary effect on managers,
mitigates two types of agency problems: empire building and quiet life. To investigate this we follow
Giroud and Mueller (2010) and estimate our main specification in Table 2 using proxies for empire
building and quiet life as dependent variables. The empire building proxies are capital expenditures over
total assets, growth of total asset and growth of property plant and equipment, and the results are in Panel
A of Table 8. Regardless of which proxy we use, the interaction term between the treatment dummy (i.e.,
tariff cuts) and post-shock dummy is not statistically significant. These results are not consistent with the
empire building tendencies, whereby managers insulated from foreign competitive pressure seek to

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overinvest and build empires, declining following the increase in foreign competition. 27

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In Panel B of Table 8, we estimate our main specification using various proxies for quiet life as
the dependent variable. The quiet life proxies are selling, general, and administrative expenses over total

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assets, advertising expenses over sales and R&D expenses over total assets. Regardless of which proxy
we use, the interaction term between treatment and post-shock is not statistically significant. These results
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are not consistent with quiet-life type behavior, whereby managers insulated from foreign competitive
pressure seek to avoid exerting the required effort, declining following the increases in competition.
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In sum, using various proxies for managerial empire building and quiet life tendencies, we do not
find evidence that increased competition mitigated either of these agency problems (see Table 8). These
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findings are important as they suggest that in our experiment at least the main effect of the change in
foreign competition on option compensation is not through its effect on the likelihood of managerial rent
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extraction evidenced by managerial empire building or quiet life tendencies. That said, we are not
claiming that competition does not have a disciplinary effect that makes rent extraction by managers less
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likely, only that we do not find evidence of this effect in our setting.
Next, we examine the risk-based story – that competition affects risk and boards adjust option
compensation to better align the risk incentives of the CEO with those of the shareholders. Consistent
with this explanation Hellmann, Murdock and Stigliz (2000) show theoretically that firms are likely to
take more risk when faced with more competition, and Gaspar and Massa (2006) and Irvine and Pontiff
(2009) provide empirical evidence that idiosyncratic volatility is higher in more competitive industries.
We therefore investigate if increased competition affects firm risk in our setting. To the extent that
managers are motivated by financial incentives, portfolio vega affects how managers respond to the
increase in risk. We therefore also investigate how managers who had higher vegas pre-shock react to the

27
Srinivasan (2020), using similar tariff reductions as a quasi-natural experiment, shows firms that face higher level of foreign
competition are more likely to make acquisitions. To the extent that firms also build empires through the means of acquisitions,
this is in contrast to the notion that enhanced foreign competition reduces the tendency to build empires.
 Journal Pre-proof

tariff reductions.
To this end, we follow the methodology in Gormley et al. (2013). We use a one-year window
before and after the shock to make it less likely that the effect of competition on firm risk is contaminated
by the follow up adjustment in option compensation which is known to affect both corporate risk taking
and firm risk. Similar to Gormley et al. (2013), we measure firm risk by stock price volatility (the
logarithm of the variance of the firm’s daily stock returns using 365 days historical daily returns). We
conduct triple difference regressions with firm risk as the dependent variable where we interact lagged
CEO compensation vega with our DID coefficient. 28
The results are in Table 9. We find that the coefficient on the interaction variable
(Treated*Shock) is positive and significant, which is consistent with enhanced foreign competition

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increasing firm risk. We also find the triple difference coefficient is positive and significant at the 10%

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level in both specifications suggesting that treated firms with managers with higher compensation vega
increase firm risk more following the tariff cuts. As CEOs with higher vega (i.e., more convex payoffs)

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have more to gain from increasing risk, the larger increase in firm risk for these firms is consistent with
risk-incentive pay leading to increased risk-taking by executives. This is also consistent with the tariff
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shocks increasing the marginal value of risk-taking.
Together the above results suggest that option compensation has a meaningful effect on risk
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taking. They are also consistent with the risk-based explanation that boards reduce option pay in the years
following the increase in competition. This is because a downward adjustment in option pay may be
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required to offset the increase in firm risk induced by the increase in foreign competition.29 Finally, these
findings are not predicted or explained by the rent extraction explanation. In totality although it is
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certainly possible that both channels operate at the same time, we find more evidence consistent with the
risk-based channel than the rent extraction channel.
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6 Cross-sectional Heterogeneity: CEO Risk Aversion

Employing a difference-in-differences methodology, we have showed that managers are, on
average, offered compensation contracts with less risk-incentive pay when product market competition

28
These specifications are similar to our main specifications in Table 2, but also include lagged CEO vega. The results are
obtained using either total or current CEO vega.
29
It is crucial for this test that we use a short window of one year before and one year after the shock as we are interested i n
investigating whether CEOs with higher level of compensation vega act differently after facing increased competition-induced
risk but before boards adjust their compensation contracts. However, a caveat is that managers may anticipate how contracts are
likely to change in response to the tariff shocks – and adjust firm policy immediately after the shock.
 Journal Pre-proof

increased due to heightened foreign entry. We now test another prediction of our theoretical framework
(see the discussion in section 2), that this reduction in risk-taking incentives is larger for firms with
managers with a low degree of risk aversion.
We measure CEO risk aversion by whether a CEO holds an aircraft pilot license. Zuckerman
(1971, 2007) argues that wanting to fly an aircraft is a strong predictor of the thrill and adventure seeking
component of sensation seeking personalities – a genetic personality trait that is correlated with a
propensity towards risk-taking behavior. Cain and McKeon (2016) document that operating small aircraft
is a risky activity that exposes the CEO to a greater level of health risk. Moreover, as CEO pilots are
unlikely to be experienced pilots (i.e., they fly as a hobby) this further exacerbates the risk. Therefore,
holding a pilot license may reveal a nonpecuniary CEO risk preference outside the scope of the firm

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which may have implications for corporate policies. Consistent with CEO pilots being less risk-averse,

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Cain and McKeon (2016) find that pilot CEOs manage firms that have higher equity return volatility and
leverage. Moreover, Sunder, Sunder and Zhang (2017) find that flying airplanes by corporate CEOs is

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associated with significantly better innovation outcomes, measured by patents and citations, greater
innovation effectiveness, and more diverse and original patents. They conclude that this evidence is
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congruent with pilot CEOs being sensation seeking which in turn leads to higher tolerance for risk.
An advantage of using whether or not the CEO holds a pilot license as a proxy for CEO risk
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aversion is that CEOs’ choice of holding a pilot license is relatively exogenous. The CEOs’ decision to
operate small aircraft as a hobby is unlikely to be affected by firm conditions as this is likely a personal
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lifestyle choice. This implies that our risk aversion proxy is unlikely to be affected by time-variation in
product market competition or executive compensation especially in the small windows around the tariffs
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cuts.30 Another advantage of this proxy is that it is likely better able to capture a CEOs time invariant risk
aversion preferences relative to other popular risk aversion proxies. In sum, our proxy helps mitigate
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potential endogeneity and measurement errors concerns that are common with other popular risk aversion
proxies.
To identify whether a CEO holds a pilot license, we search for each CEO in our sample in the
Federal Aviation Administration’s (FAA’s) Airmen Certification database.31 If a given name does not
produce a match in the FAA’s database, then this observation is identified as a non-pilot and vice versa.
We find 13 pilot CEOs in our sample of which 9 are treated firms and 4 control firms.32 The variable Pilot

30
Although certain firms may be more likely to hire more risk-seeking CEOs (that are more likely to have a pilot’s license) and
this hiring decision may be correlated with corporate policies, we find that our results continue to hold if we only consider firms
that did not have any CEO turnover during our event window (see section 4.4).
31
See https://amsrvs.registry.faa.gov/airmeninquiry/. The FAA Web site provides a downloadable database of airmen certificate
information.
32
The percentage of pilot CEOs in our sample (5.4%) is consistent with those reported in Cain and McKeon (2016) (5.6%) and in
Sunder et al. (2017) (7.8%).
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CEO is an indicator variable that equals 1 if, the CEO holds a pilot license and zero otherwise.
Next, we run a triple differences regression where the term of interest is Treated × Shock × Pilot
CEO. The results are reported in Panel A of Table 10. As we hypothesized, the triple interaction term is
negative and statistically significant. This is consistent with increases in product market competition
being more likely to lead to firms adjusting managerial risk-incentive pay downwards when the manager
has a low degree of risk aversion. That is, for low degrees of managerial risk aversion, product market
competition and risk-taking incentives are more likely to act as substitutes in mitigating risk-related
agency concerns.
Due to the fact that our subsample of firms with Pilot CEOs is relatively small, we also measure
CEO risk aversion with CEO age. The literature on how age is related to risk aversion suggests that older

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economic agents are generally more risk-averse (Pålsson (1996), Morin and Suarez (1983)). Additionally,

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Serfling (2014) finds that younger CEOs take more risk. Therefore, we use CEO age as an additional
proxy for CEO risk aversion, i.e., older CEO are more risk-averse.

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In Panel B of Table 10 we replicate all the tests in Panel A replacing Pilot CEO with Junior CEO
as an alternative proxy for CEO risk aversion. Junior CEO is a dummy variable that equals one if the
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CEO is younger than 60 and zero otherwise. When using this alternative measure of risk-aversion, the
coefficient on the triple interaction terms is negative and statistically significant for both current and total
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vega which is consistent with the results in Panel A. However, in contrast to Panel A of Table 10, in Panel
B of Table 10 we find that the double difference term is positive (but mostly insignificant). This provides
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some evidence consistent with the reduction in risk taking incentives after the tariff cuts being driven by
firms with less risk-averse CEOs. Overall, the evidence in Panel B of Table 10 further strengthens our
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findings that the average firm responds to more intense competition by reducing risk-incentives, an effect
that is stronger for less risk-averse CEOs.
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The use of CEO age as risk aversion is subject to some important caveats. First, some studies find
that older managers may be less risk-averse. 33 For example, Chevalier and Ellison (1999), in the context
of mutual fund managers, argue that due to their career concerns younger managers would be more
conservative because their future career opportunities are punished by poor performance. Moreover, CEO
age suffers from endogeneity concerns when used as a proxy for CEO risk aversion.
For robustness we also use two other measures of risk aversion to verify our findings. First, we
use the ratio of the pre-treatment CEO total compensation vega to firm risk (measured by the logarithm of

33
Risk aversion may also not increase monotonically with age. Consistent with this Riley and Chow (1992) find that for people
below 65 risk aversion decreases with age. However, among people older than 65 years risk aversion increases with age.
 Journal Pre-proof

the variance of the firm’s daily stock returns). It is reasonable to assume that firms managed by more risk-
averse CEOs have lower return volatility and compensate their CEOs with higher level of risk-incentive
pay measured by the total compensation vega. The idea is that, firms that pay stronger risk-incentive
compensation to their CEOs and have lower return volatility, have CEOs who are more likely to be
intrinsically more risk-averse. We acknowledge that this is not a perfect proxy. For example, more risk-
averse managers are more likely to be matched with firms that offer compensation contracts with lower
vega.
The second alternative risk aversion proxy we use is CEO tenure. Since CEOs are often paid in
stock and option grants whose sale or exercise is restricted, CEO’s with longer tenure are likely to have
more wealth tied to the firm. Moreover, the CEO’s human capital will be disproportionately invested in

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the firm (Hall and Murphy (2002)) and this effect is likely to strengthen the longer the CEO stays on.

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Thus, longer tenured CEO will tend to be more under-diversified, which may induce them to take less
risky decisions (i.e., exhibit more risk-averse behavior).

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In Table D.5 in the Internet Appendix we repeat the tests in Table 10 replacing Pilot CEO with
Vega-to-Risk and Short-Tenure Dummy as our proxies for CEO risk aversion. Consistent with the results
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in Table 10, when using these alternative measures of risk-aversion, the coefficients on the triple
interaction terms are negative and statistically significant for both current and total vega. This bolsters our
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finding that on average firms respond to more intense competition by decreasing risk-incentives, an effect
that is more pronounced for less risk-averse CEOs. Unlike our findings with Pilot CEOs these two
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auxiliary results – just like our results with CEO age – come with significant caveats due to endogeneity
and measurement error concerns of both these alternate risk aversion proxies. Nonetheless, it is
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comforting that our results are similar for four separate proxies of risk aversion.

7. Concluding Remarks
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How do firms optimally adjust managerial compensation in response to changes in product

market competition brought about by increased foreign entry? We explore this question by analyzing one
particular aspect of the managerial compensation contract, namely the amount of risk-taking incentives
offered, and how it interacts with the level of foreign competition in the product market. Product market
competition can have either a positive or negative effect on CEO risk-incentive compensation – and an
important factor determining whether the positive or negative effect dominates is likely the manager’s
appetite towards risk. To discover which prevails empirically, we use a quasi-natural experiment: tariff
cuts induced by the ratification of large trade deals in the mid-90s talks. The evidence from this
experiment suggests that on average foreign competition has a negative effect on risk-incentive pay. That
is, when foreign competition exogenously increases, firms on average offer their CEOs less risk-taking
 Journal Pre-proof

incentive compensation. Intuitively, intensification in domestic product market competition due to the
increased foreign competition increases the marginal value of the manager’s option holdings (i.e., existing
risk-taking incentives) which leads managers to voluntarily take on more risk, and they therefore do not
need to be incentivized with as much option pay. We find that this result is stronger for firms with CEOs
that are less risk-averse as managers with lower risk aversion voluntarily take on more risk when
competition increases and therefore require less risk-incentive compensation.

of
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We are grateful to Daniel Hungerman, Janya Golubeva, Peter MacKay, Bill Megginson, Mehdi Mohseni, Pradeep
Yadav, and seminar participants at the MFA, RES, University of Notre Dame, and University of Oklahoma for

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helpful comments. Jeff Black, Karim Farroukh, Fang Lin and Kelly Zhang provided excellent research assistance.
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Declarations of interest
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Tor-Erik Bakke – None

Felix Feng - None
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Hamed Mahmudi - None

Caroline Zhu – None
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Contributions:
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Tor-Erik Bakke – Contributed to all parts of the article

Felix Feng – Contributed to all parts of the article
Hamed Mahmudi – Contributed to all parts of the article
Caroline Zhu – Contributed to all parts of the article

All of the coauthors contributed equally and contributed to all parts of the article.

All authors have approved the final article.

 Journal Pre-proof

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Figure 1—Tariff Cuts Experiment: Changes in tariffs and import penetration

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Panel A: Tariffs

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Panel B: Import Penetration
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na
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The figures show changes in tariffs (Panel A) and import penetration (Panel B) for two years before to two years
after the implementation of the tariff cuts for the treated firms, indicated by the solid blue line, and the control firms,
indicated by the dashed red line. When calculating the average in each group, the value for each industry is weighted
by the ratio of the number of treated or control firms in that industry to the total number of treated or control firms
(in that year). All three tariff cuts (1995, 1997, 1998) are included.
.
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Figure 2 – Dynamic Model of Changes in Tariffs and Import Penetration

Panel A: Tariffs

𝛽𝑗

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Panel B: Import Penetration

-p
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lP
𝛽𝑗

na
ur
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This figure plots coefficient estimates and the 95% confidence intervals from the following dynamic DID
specification:
𝑡+1 𝑡+1

𝑌𝑖,𝑡 = 𝛼 + ∑ 𝛽𝑗 ∙ 𝑡𝑟𝑒𝑎𝑡𝑒𝑑𝑖 × 1[𝑌𝑒𝑎𝑟 = 𝑗] + ∑ 𝜃𝑗 ∙× 1[𝑌𝑒𝑎𝑟 = 𝑗] + 𝜀𝑖,𝑡

𝑗=𝑡−1 𝑗=𝑡−1

The dependent variables are average tariffs (Panel A) and average import penetration (Panel B) in the three-year
window around the treatment year (year = 0). The omitted year, and thus the benchmark year, is year t-2. The graph
displays the coefficient estimates βj of the difference between tariffs (Panel A) and import penetration (Panel B) for
treated and control firms around the tariff cuts. The sample is the same as the main sample used in Table 2.

Figure 3—Tariff Cuts Experiment: Pre-Post Trends

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Panel A: Total Vega

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Panel B: Current Vega
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na
ur
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This figure displays the trends in vega (Panel A) and current vega (Panel B) in the two-years period before the tariff
cuts (years 1 and 2) and the two years after the tariff cuts (years 3 and 4). Only firms with four years of observations
(i.e., two on each side of the shock) are included. All three tariff cuts (1995, 1997, 1998) are included.
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Figure 4 – Dynamic Model of Changes in Total and Current Vega

Panel A: Total Vega

𝛽𝑗

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Panel B: Current Vega

-p
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𝛽𝑗

na
ur
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This figure plots coefficient estimates with 95% confidence interval from the following dynamic DID specification:
𝑡+1 𝑡+1

𝑌𝑖,𝑡 = 𝛼 + ∑ 𝛽𝑗 ∙ 𝑡𝑟𝑒𝑎𝑡𝑒𝑑𝑖 × 1[𝑌𝑒𝑎𝑟 = 𝑗] + ∑ 𝜃𝑗 ∙× 1[𝑌𝑒𝑎𝑟 = 𝑗] + 𝜀𝑖,𝑡

𝑗=𝑡−1 𝑗=𝑡−1

The dependent variables are total vega (Panel A) and current vega (Panel B) in the three-year window around the
treatment year (year = 0). The omitted year, and thus benchmark, is year t-2. The graph displays the coefficient
estimates 𝛽𝑗 of the difference in total vega (Panel A) and current vega (Panel B) for treated and control firms around
the tariff cuts. The sample is the same as the main sample used in Table 2.

Table 1—Tariff Cuts Experiment: Summary Statistics

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Panel A, B and C contains summary statistics for the tariff cuts experiment. The sample includes 107 treated and
107 matched control firms which results in 756 firm-year observations from two-year event windows surrounding
the tariff cuts in 1995, 1997 and 1998. Using propensity score matching, treated firms are matched with control
firms from industries that did not experience a tariff cut based on the following firm characteristics in the pre-shock
period: market-to-book, assets, book leverage, cash flow volatility and volatility of daily stock returns. The pre-
shock period is defined as two fiscal years prior to the event and the post-shock period is defined as two fiscal years
following the event. Panel A, B and C contains summary statistics for the full matched sample that includes treated
and matched control firms, treated and matched control groups for all years reported separately and treated and
matched control groups in the pre-shock period only, respectively. * indicates that mean or median of the variable in
control groups and treated groups is significantly different at 10% using t-test for means and Wilcoxon signed rank
sum test for medians. All variables are winsorized at the 1% level (two-tailed) and are defined in Appendix A.

Panel A: Full Matched Sample

of
Mean Standard Deviation 25th Percentile Median 75th Percentile
Ln(1+Total Vega) 3.088 1.567 2.266 3.217 4.163

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Ln(1+Current Vega) 1.918 1.522 0.000 2.056 3.076
Asset (total) 2563 5532 239 725 1786
Market-to-book 2.432
0.160
1.531
0.140
-p 1.439
0.025
1.958
0.145
2.845
0.252
re
Leverage (Book)
Cash Flow Volatility 0.070 0.066 0.033 0.049 0.083
lP

CAPEX 0.054 0.034 0.031 0.047 0.070

Cash Ratio 0.168 0.195 0.027 0.084 0.256
Firm Age 55.960 8.120 52 56 61
na

Firm Risk -7.574 0.876 -8.306 -7.644 -6.913

Export/Sales Ratio 0.104 0.240 0.000 0.000 0.115
ur

Ln(Total compensation) 7.418 0.887 6.788 7.384 8.076

Ln(Cash compensation) 6.679 0.710 6.182 6.672 7.170
Jo
 Journal Pre-proof

Panel B: Comparison of Treated and Control Group (Full Matched Sample)

Treated Group Control Group
Mean Median N Mean Median N
Ln(1+Total Vega) 3.435* 2.621 375 2.747 1.754 381
Ln(1+Current Vega) 2.220* 1.190 375 1.620 0.000 381
Asset (total) 3082* 256 375 2054 223 381
Market-to-book 2.482 1.578 375 2.383 1.324 381
Leverage (Book) 0.174* 0.060 375 0.146 0.013 381
Cash Flow Volatility 0.070 0.029 375 0.071 0.036 381
CAPEX 0.052 0.031 375 0.055 0.031 381

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Cash Ratio 0.170 0.031 375 0.166 0.020 381
Firm Age 55.821 52 375 56.097 52 381

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Firm Risk -7.535 -8.305 375 -7.613 -8.306 381
0.101 0.000 375 0.107 0.000 381
Export/Sales ratio
Ln(Total compensation) 7.487
6.678
7.439
6.676
375
375
-p
7.350
6.680
7.307
6.670
381
381
re
Ln(Cash compensation)
Panel C: Comparison of Treated and Control Group (Pre-shock period)
lP

Treated Group Control Group

Mean Median N Mean Median N
Ln(1+Total Vega) 3.312* 3.486 180 2.435 2.725 189
na

Ln(1+Current Vega) 2.162* 2.335 180 1.324 1.162 189

Asset (total) 2991* 737 180 1918 667 189
ur

Market-to-book 2.343 2.121 180 2.319 1.737 189

Leverage (Book) 0.169* 0.151 180 0.134 0.116 189
Jo

Cash Flow Volatility 0.065 0.044 180 0.071 0.049 189

CAPEX 0.057 0.050 180 0.057 0.048 189
Cash Ratio 0.162 0.081 180 0.168 0.094 189
Firm Age 56.24 56.50 180 55.62 56.00 189
Firm Risk -7.647 -7.727 180 -7.646 -7.760 189
Export/Sales ratio 0.086 0.000 180 0.087 0.000 189
Ln(Total compensation) 7.442 7.395 180 7.490 7.490 189
Ln(Cash compensation) 6.639 6.700 180 6.762 6.783 189
 Journal Pre-proof

Table 2—Tariff Cuts Experiment: The Difference-in-Differences Results

This table reports difference-in-differences (DID) regression results for the tariff cuts experiment. The dependent
variables are Ln(1+Total Vega) and Ln(1+Current Vega). Shock is a dummy variable that equals one for firm-year
observations in the post-shock period (i.e., if the firm-year is in the year of the tariff cuts or the year after) and zero
otherwise. Treated is a dummy variable that equals one if the firm belongs to an industry that is affected by a tariff
cut and zero otherwise. Treated*Shock is the DID estimate. Standard errors are clustered at the firm level.
Parentheses enclose t-statistics. *, **, *** denote statistical significance at the ten, five, and one percent levels,
respectively. All variables are defined in Appendix A.
Ln(1+Total Vega) Ln(1+Current Vega) Ln(1+Total Vega) Ln(1+Current Vega)

Shock 0.619*** 0.587*** 0.535*** 0.523***

(4.385) (3.174) (4.062) (3.284)

of
Treated 0.877*** 0.838*** 0.737*** 0.714***
(3.284) (4.283) (3.195) (4.192)
Treated -0.383** -0.475** -0.363** -0.455**

ro
*Shock (-2.369) (-2.203) (-2.340) (-2.310)

Asset (total)
-p 0.000***
(4.242)
0.000***
(3.744)
re
Market-to-book 0.210*** 0.194***
(4.220) (4.263)
Leverage (book) 2.575*** 2.122***
lP

(3.342) (3.726)
Cash Flow Volatility 2.098* 0.703
(1.728) (0.629)
na

CAPEX 1.134 1.885

(0.419) (1.057)
ur

Cash Ratio -0.164 0.182

(-0.292) (0.403)
Firm Age -0.029* -0.033***
Jo

(-1.846) (-3.603)
Firm Risk -0.354*** -0.334***
(-3.045) (-3.528)
Export/Sales Ratio 0.505** 0.292
(2.034) (1.413)
Compensation Delta 0.000 0.000
(0.385) (0.844)
R2 0.071 0.058 0.288 0.271
N 756 756 756 756
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Table 3—Analysis of Changes in Vega on Changes in Tariff/Import Penetration around

Changes in Tariffs
This table reports regressions of changes in compensation vega on changes in tariffs and changes in import
penetration around the tariff cuts. Changes () are calculated as the change in the averages of the variables in the
two-year pre-shock window and the two-year post-shock window. The dependent variables are changes in
Ln(1+Total Vega) and Ln(1+Current Vega). Standard errors are clustered at the firm level. Parentheses enclose t-
statistics. *, **, *** denote statistical significance at the ten, five, and one percent levels, respectively. All variables
are defined in Appendix A.
Total Vega Current Vega Total Vega  Current Vega

Tariff 0.105*** 0.141**

(3.011) (1.987)
Import Penetration

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-9.560** -7.248*
(-2.545) (-1.668)
Asset (total)

ro
-0.000* -0.000 -0.000** -0.000
(-1.752) (-0.521) (-2.182) (-0.777)
Market-to-book 0.038 0.062 0.044 0.058

Leverage (book)
(0.807)
-0.052
-p
(1.017)
-0.224
(1.147)
-0.006
(1.053)
-0.251
re
(-0.112) (-0.281) (-0.012) (-0.316)
Cash Flow Volatility -1.378 1.955 -1.335 2.269
lP

(-1.194) (1.007) (-1.316) (1.206)

CAPEX -1.057 -2.595 -0.811 -2.207
(-0.684) (-1.072) (-0.594) (-0.913)
na

Cash Ratio 0.408 -0.904 0.157 -1.294*

(1.066) (-1.340) (0.403) (-1.920)
Firm Age -0.015 -0.025 -0.001 -0.012
ur

(-0.961) (-1.450) (-0.071) (-0.886)

Firm Risk 0.044 -0.107 0.038 -0.105
Jo

(0.522) (-0.775) (0.442) (-0.748)

Export/Sales Ratio 0.079 -0.318 0.287 -0.016
(0.296) (-0.629) (1.130) (-0.034)
Compensation Delta 0.000*** 0.000** 0.000*** 0.000***
(3.094) (2.547) (6.063) (2.628)
R2 0.128 0.109 0.319 0.292
N 214 214 214 214
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Table 4— Tariff Cuts Experiment: The Difference-in-Differences Results for CEO

Subjective Compensation Vega
This table reports difference-in-differences (DID) regression results for the tariff cuts experiment. The dependent
variables are Ln(1+Total Subjective Vega) and Ln(1+Current Subjective Vega). Subjective Vega is calculated based
on the certainty equivalent approach in Ingersoll (2006) following the methodology in Peters and Wagner (2014).
Shock is a dummy variable that equals one for firm-year observations in the post-shock period (i.e., if the firm-year
is in the year of the tariff cuts or the year after) and zero otherwise. Treated is a dummy variable that equals one if
the firm belongs to an industry that is affected by a tariff cut and zero otherwise. Treated*Shock is the DID estimate.
Standard errors are clustered at the firm level. Parentheses enclose t-statistics. *, **, *** denote statistical
significance at the ten, five, and one percent levels, respectively. All variables are defined in Appendix A.

Ln(1+Total Ln(1+Current Ln(1+Total Ln(1+Current

Subjective Vega) Subjective Vega) Subjective Vega) Subjective Vega)

of
Shock 0.495*** 0.473*** 0.428*** 0.425***

ro
(5.032) (3.555) (4.579) (3.699)
Treated 0.740*** 0.625*** 0.604*** 0.511***

Treated
*Shock
(3.039)
-0.328***
(-2.618)
(3.669)
-0.390**
(-2.415)
-p (3.048)
-0.251**
(-2.002)
(3.712)
-0.335**
(-2.236)
re
Asset (total) 0.000*** 0.000***
lP

(4.537) (4.157)
Market-to-book 0.181*** 0.161***
(3.905) (3.670)
na

Leverage (book) 1.802** 1.365***

(2.526) (2.732)
Cash Flow
ur

Volatility 0.979 0.042

(0.783) (0.044)
Jo

CAPEX 1.502 2.167

(0.613) (1.411)
Cash Ratio -0.731 -0.342
(-1.457) (-0.942)
Firm Age -0.019 -0.022***
(-1.439) (-2.797)
Firm Risk -0.480*** -0.361***
(-4.161) (-4.146)
Export/Sales
Ratio 0.310 0.156
(1.311) (0.868)
Compensation
Delta 0.000 0.000
(0.783) (1.109)
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R2 0.051 0.044 0.350 0.331

N 756 756 756 756
Table 5—Tariff Cuts Experiment: The Difference-in-Differences Results for Exports
This table reports difference-in-differences (DID) regression results for the tariff cuts experiment. The dependent
variable is Exports/Sales ratio. Shock is a dummy variable that equals one for firm-year observations in the post-
shock period (i.e., if the firm-year is in the year of the tariff cuts or the year after) and zero otherwise. Treated is a
dummy variable that equals one if the firm belongs to an industry that is affected by a tariff cut and zero otherwise.
Treated*Shock is the DID estimate. Standard errors are clustered at the firm level. Parentheses enclose t-statistics. *,
**, *** denote statistical significance at the ten, five, and one percent levels, respectively. All variables are defined
in Appendix A.
Export/Sales Ratio Export/Sales Ratio

of
Shock 0.041* 0.040*
(1.747) (1.760)

ro
Treated -0.000 -0.009
(-0.008) (-0.379)
Treated -0.013 -0.034
*Shock
-p
(-0.461) (-1.090)
re
Asset (total) 0.000*
(1.817)
lP

Market-to-book -0.004
(-0.554)
Leverage (book) -0.078
na

(-0.667)
Cash Flow Volatility -0.195
(-0.510)
ur

CAPEX -0.493
(-1.229)
Jo

Cash Ratio 0.020

(0.183)
Firm Age 0.000
(0.234)
Firm Risk 0.100***
(3.227)
Compensation Delta -0.000***
(-3.522)
R2 0.006 0.129
N 756 756

Table 6—Placebo Test

This table reports the placebo difference-in-differences (DID) regression results for the tariff cuts experiment. The
dependent variables are Ln(1+Total Vega) and Ln(1+Current Vega). For both placebo experiments (Panel A and B),
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we use the years 2001, 2003 and 2004 as placebo shock years. The treated firms are the same as in Table 2. Treated
firms are assigned to placebo years chronologically according to when the firm was treated. For example, firms that
were treated in 1995 are assigned to 2001; firms that were treated in 1997 are assigned to 2003 etc. For the first
placebo experiment (Panel A), we keep all the control firms the same, but in the second placebo experiment (Panel
B) we define control firms as firms that are propensity score matched using the same matching methodology as in
Table 2, but using 2 years of data from the placebo pre-event period. Standard errors are clustered at the firm level.
Parentheses enclose t-statistics. *, **, *** denote statistical significance at the ten, five, and one percent levels,
respectively. Control variables are the same as in Table 2. All variables are defined in Appendix A.
Panel A: Same control firms
Ln(1+Total Vega) Ln(1+Current Vega) Ln(1+Total Vega) Ln(1+Current Vega)

Shock 0.435*** -0.032 0.205 0.122

(4.336) (-0.143) (1.384) (0.613)

of
Treated 0.763** 0.859*** 0.699*** 0.665**
(2.462) (2.879) (2.781) (2.574)

ro
Treated -0.013 -0.022 -0.222 -0.189
*Shock (-0.090) (-0.082) (-1.492) (-0.866)

Controls
R2
No
0.064
No
0.051 -p Yes
0.440
Yes
0.310
re
N 603 603 603 603
lP

Panel B: Control firms matched using data from the placebo pre-event period
Ln(1+Total Vega) Ln(1+Current Vega) Ln(1+Total Vega) Ln(1+Current Vega)
na

Shock 0.157 0.311** 0.111 0.064

(1.218) (2.312) (0.799) (0.432)
Treated 1.050*** 1.086*** 0.981*** 0.909***
(3.036) (3.799) (3.755) (4.034)
ur

Treated -0.168 0.079 -0.265 0.047

*Shock (-1.060) (0.395) (-1.595) (0.229)
Jo

Controls No No Yes Yes

R2 0.070 0.105 0.405 0.369
N 608 608 608 608

Table 7—Tariff Cuts Experiment: Compensation Delta and Cash Compensation

This table reports the results of difference-in-differences (DID) regression for the tariff cuts experiment. The
dependent variable in the first and third columns is CEO compensation delta while in the second and fourth columns
the dependent variable is CEO cash compensation. Shock is a dummy variable that equals one for firm-year
observations in the post-shock period (i.e., if the firm-year is in the year of the tariff cuts or the year after) and zero
otherwise. Treated is a dummy variable that equals one if the firm belongs to an industry that is affected by a tariff
cut and zero otherwise. Treated*Shock is the DID estimate. Standard errors are clustered at the firm level.
Parentheses enclose t-statistics. *, **, *** denote statistical significance at the ten, five, and one percent levels,
respectively. All variables are defined in Appendix A.
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Compensation Delta Cash Pay Compensation Delta Cash Pay

Shock 306.913 163.529** 363.251 132.684**

(1.525) (2.335) (1.255) (2.448)
Treated -230.076** 84.768 -217.523 5.001
(-2.420) (1.222) (-1.491) (0.060)
Treated -249.223 -122.102 -332.042 -85.575
*Shock (-1.189) (-1.201) (-1.001) (-1.395)

Asset (total) 0.033* 0.059***

(1.871) (4.787)
Market-to-book 72.310 91.003**

of
(1.579) (2.078)
Leverage (book) -883.116 244.531
(-1.504) (0.986)

ro
Cash Flow Volatility 644.190 387.209
(0.345) (0.627)
CAPEX
-p 239.289
(0.080)
-687.385
(-0.762)
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Cash Ratio -188.243 -352.780
(-0.534) (-1.388)
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Firm Age -27.399 9.900

(-0.858) (1.362)
Firm Risk 32.506 -169.994***
na

(0.415) (-4.174)
Export/Sales Ratio -729.045* -95.586
(-1.921) (-0.679)
R2
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0.020 0.008 0.082 0.430

N 756 756 756 756
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Table 8— Tariff Cuts Experiment: Empire Building and Quiet Life Hypotheses
This table reports difference-in-difference regression results for the tariff cuts experiment. In Panel A the dependent
variables are proxies for empire building: Capital Expenditure, Asset Growth measured by the percentage increase
in total assets, and PPE Growth measured by the percentage increase in property, plant, and equipment. In Panel B
the dependent variables are proxies for quiet life: Selling, General & Administrative Expenses measured by selling,
general & administrative expenses divided by total assets, Advertising Expenses measured by advertising expenses
divided by sales, and R&D Expenses measured by R&D expenses divided by total assets. Standard errors are
clustered at the firm level. Parentheses enclose t-statistics. *, **, *** denote statistical significance at the ten, five,
and one percent levels, respectively. All variables are defined in Appendix A.

Panel A: Empire Building

Capital Expenditures Asset Growth PPE Growth

Shock -0.003 0.057* -0.000

 Journal Pre-proof

(-0.863) (1.717) (-0.023)

Treated 0.000 -0.004 0.000
(0.066) (-0.173) (0.440)
Treated * Shock -0.006 0.008 -0.001
(-1.584) (0.195) (-0.839)

R2 0.011 0.011 0.002

N 756 756 756

Panel B: Quiet Life

Selling, General & Admin Expenses Advertising Expenses R&D Expenses

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Shock 0.005 0.021 0.000

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(0.656) (0.928) (0.117)
Treated 0.117*** 0.025 0.042***
(3.447) (0.910) (4.736)
Treated * Shock 0.023
(1.402)
-p -0.014
(-0.441)
0.003
(0.686)
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R2 0.049 0.003 0.103
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N 756 756 756

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Table 9— Tariff Cuts Experiment: The Effect of Competition and CEO Vega on Risk
This table reports difference-in-difference-in-difference regression results for the tariff cuts experiment. The
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dependent variable is Firm Risk measured by the logarithm of the variance of the firm’s daily stock returns using
365 days historical daily returns. In column (1) VegaT-1 refers to CEO total vega in the year before the change in
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tariffs and in column (2) VegaT-1 refers to CEO current vega in the year before the change in tariffs. Both
specifications include control variables similar to those in Table 2 in the paper. Standard errors are clustered at the
firm level. Parentheses enclose t-statistics. *, **, *** denote statistical significance at the ten, five, and one percent
levels, respectively. All variables are defined in Appendix A.
Firm Risk Firm Risk
(stock price vol.) (stock price vol.)

Shock -0.045 0.088

(-0.342) (0.882)
Treated 0.031 -0.025
(0.391) (-0.424)
Treated * Shock 0.346*** 0.177*
(2.801) (1.846)
Treated * VegaT-1 0.003 0.005*
(0.662) (1.968)
 Journal Pre-proof

Shock * VegaT-1 -0.003*** -0.002***

(-2.695) (-3.520)
Treated * Shock * VegaT-1 0.009* 0.006*
(1.890) (1.678)

Measure of vega Total Current

Controls Yes Yes
R2 0.060 0.054
N 345 345

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Table 10—Tariff Cuts Experiment: CEO Risk Aversion

This table reports difference-in-difference-in-difference regression results. The dependent variables are Ln(1+Total
Vega) and Ln(1+Current Vega). Pilot CEO is a dummy variable that equals one if the CEO holds a pilot
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certification issued by the FAA and zero otherwise. Junior CEO is a dummy variable that equals one if the CEO is
younger than 60. Standard errors are clustered at the firm level. Parentheses enclose t-statistics. *, **, *** denote
statistical significance at the ten, five, and one percent levels, respectively. Control variables are the same as in
ur

Table 2. All variables are defined in Appendix A.

Panel A: Pilot CEO

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Ln(1+Total Ln(1+Current Ln(1+Total Ln(1+Current

Vega) Vega) Vega) Vega)

Shock 0.588*** 0.562*** 0.502*** 0.500***

-4.16 -3.012 (3.829) (3.104)
Treated 0.886*** 0.860*** 0.722*** 0.717***
-3.211 -4.24 (3.030) (4.052)
Pilot CEO -0.921 -0.471 -1.084 -0.522
(-1.153) (-1.039) (-1.315) (-1.197)
Treated * Shock -0.356** -0.468** -0.333** -0.454**
(-2.177) (-2.124) (-2.108) (-2.249)
Treated * Pilot CEO 0.388 -0.087 0.862 0.253
-0.46 (-0.165) (0.987) (0.485)
Shock * Pilot CEO 2.273*** 2.818*** 1.802** 2.256***
 Journal Pre-proof

-2.95 -6.205 (2.232) (5.127)

Treated * Shock * Pilot
CEO -2.152*** -2.510*** -1.757** -1.913***
(-2.708) (-4.717) (-2.028) (-3.468)
Controls No No Yes Yes
R2 0.077 0.064 0.292 0.274
N 756 756 756 756

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Table 10 (continued)

Panel B: CEO Age

Ln(1+Total Ln(1+Current Ln(1+Total Ln(1+Current
Vega) Vega) Vega) Vega)

Shock -0.359 0.162 -0.352 0.187

(-0.910) (0.558) (-1.169) (0.700)
Treated 1.007 0.807* 0.984 0.797**
(1.383) (1.853) (1.584) (2.006)
Junior CEO 0.688 0.854*** 0.568 0.770**
(1.117) (2.810) (1.037) (2.289)
Treated * Shock 1.104* 0.322 0.909* 0.129

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(1.934) (0.667) (1.949) (0.294)
Treated * Junior CEO -0.139 0.056 -0.281 -0.083

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(-0.181) (0.119) (-0.425) (-0.192)
Shock * Junior CEO 1.170** 0.517 1.043*** 0.383

Treated * Shock * Junior

CEO
(2.558)

-1.774***
-p
(1.357)

-0.978*
(3.004)

-1.479***
(1.167)

-0.679
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(-2.815) (-1.732) (-2.940) (-1.364)
Controls No No Yes Yes
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R2 0.128 0.109 0.319 0.292

N 756 756 756 756
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 Journal Pre-proof

Appendix A - Definition of Variables

Total Vega: CEO total compensation vega is the change in the dollar value (in thousands of dollars) of
the executive’s wealth derived from the ownership of stock and stock options in the firm when the
annualized standard deviation of the firm’s stock price changes by 0.01. We obtain the total vega of the
executive’s compensation as the sum of the vegas of the executive’s options holdings. Total vega is
estimated as the vega of options holdings and is calculated based on the methodology in Guay (1999) and
Core and Guay (2002).

Current Vega: CEO current compensation vega is the change in the dollar value (in thousands of dollars)
of the executive’s wealth derived from the newly granted of stock and stock options in the firm when the
annualized standard deviation of the firm’s stock price changes by 0.01. We obtain the current vega of the
executive’s compensation as the vegas of the executive’s newly granted options.

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Compensation Delta: CEO total compensation delta is the change (in thousands of dollars) in the dollar

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value of the executive’s wealth derived from ownership of stock and stock options in the firm when the
firm’s stock price changes by one percent. We calculate the delta of the executive’s compensation as
the sum of the deltas of the options holdings and the delta of the stock holdings. The delta of
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options holdings are calculated based on the methodology in Guay (1999) and Core and Guay
(2002)
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Cash Ratio: (cash + cash equivalents) / total assets.
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Cash Flow Volatility: The standard deviation of quarterly net cash flows from operating activities over
assets estimated using eight previous quarters.
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Cash Compensation: CEO Salary plus bonus in thousands of dollars.

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Leverage: Book value of long-term debt divided by the sum of book values of preferred stock, common
equity, and long-term debt.
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Capital Expenditure: Property, plant and equipment / total assets

Total Compensation: CEO compensation (ExecuComp TDC1) in thousands of dollars.

Export/Sales Ratio: Total export sales / total sales

Market-to-book ratio: (Common Shares Outstanding (CSHO) * Price Close - Annual

Fiscal Year (PRCC_ F) + Book Debt (BD)) / Assets - Total (AT)

Firm Age: The number of years since the firm first appeared in Compustat

Firm Risk: The logarithm of the variance of the firm’s daily stock returns using 365 days historical daily
returns.
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Import penetration: For each four-digit SIC industry it is given by the total value of imports divided by
the sum of total value of imports and domestic production (shipments minus exports).

Tariffs: Defined in each industry defined as the custom duties collected at U.S. Custom divided by the
custom value of imports at the four-digit SIC industry.

Pilot CEO: A dummy variable that equals one if the CEO holds a pilot license issued by the FAA and
zero otherwise.

Junior CEO: A dummy variable that equals one if the CEO is younger than 60 and zero otherwise.

Asset Growth: The percentage increase in total assets.

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PPE Growth: Percentage increase in property, plant, and equipment.

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Selling, General & Admin Expenses: Selling, general, and administrative expenses divided by
total assets.
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Advertising Expenses: Advertising expenses divided by sales.

R&D Expenses: R&D expenses divided by total assets.

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Appendix B - Additional Robustness

B.1 Multiple Hypothesis Testing
The tariff cuts we study – although arguably exogenous to firm policies such as risk-incentive pay
- have been used in many other papers to study other variables of interest. The repeated use of the tariff
cuts experiment may raise potential concerns regarding whether our finding represents a causal link
between foreign competition and risk-incentive pay. In particular, reusing the same natural experiment
can increase the likelihood of false positives making spurious causal inference more likely. To address
these concerns, we follow the advice in Heath et al. (2021; hereafter HRSW) and apply multiple
hypothesis corrections to guard against our results being false positive discoveries.

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As a first step we conduct a thorough literature review of existing published and working papers
that have used the tariff cuts as a natural experiment. As stressed in HRSW, the multiple testing critique is

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applicable if the same setting is re-used (i.e., the same variation in the data is used multiple times in
testing). This implies that the papers should use similar datasets and similar empirical methods. Although

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we find 35 papers that use the tariff cut experiments in some capacity, only 15 conduct tests that are
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somewhat similar to ours (see Table B.1 for a list of these papers and pertinent details about each one).
Out of these 15 papers, we further eliminate all papers that use different empirical methodologies and
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different samples and end up with only two papers – Flammer (2015), Dasgupta et al. (2018) – that use
the same tariff cuts and a similar empirical methodology as what we do. 34
Given that only the two papers have similar methodologies and samples as we do, multiple testing
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suggests that there is a 14% chance that one of the three results (including the results in this paper) is a
false positive at the 5% level; however, this ignores any dependence in the data. To account for any
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dependence in the data HRSW recommend implementing the multiple testing corrections in Romano and
Wolf (2016). There are three ways to apply the Romano-Wolf correction: (1) sequential, (2) causal chain
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and (3) simultaneous. We examine each in turn. The sequential method assumes that the most important
variables were examined first historically. Our paper is sequentially third (i.e., it was the third to be
posted online historically). As many of the variables of interest in previous studies are difficult to collect
– and following the recommendation in HRSW - we find the adjusted t-statistics in Table 3 of HRSW

34
We investigate if the variables that are statistically significant in other studies are still statistically significant if we use our
sample and our methodology. This endeavor is informative as it sheds light on whether it is fair to exclude these studies when
using the multiple testing corrections in HRSW. Similar to HRSW, we focus on replicating papers that use data that is widely
accessible. We first look at papers that use an alternate methodology (in addition to longer sample periods). Giannetti and Yu
(2021) and Grullon, Larkin and Michaely (2019) use a staggered DID methodology to study the effect of tariff cuts on sales and
dividends respectively. In Table D.4 in the Internet Appendix we find that when instead using our DID and matching
methodology as well as our shorter sample period neither sales nor dividends are statistically significant. Next, we consider a
paper that uses a similar DID methodology as we do, but a much larger sample (Fresard and Valta (2016); sample period: 1974-
2005)). Fresard and Valta find that tariff cuts reduces firm investment, however, in our sample we find that this result is not
statistically significant. In sum, for all three papers – whether using a different methodology and/or a different sample – we find
that the results do not hold in our experiment. Therefore this evidence bolsters the case for excluding these studies.
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instead of running the Romano-Wolf routine using our data. The corrected t-statistic in this case is 2.19
while our t-statistics range from 2.2 to 2.37 (p-values: 0.028 to 0.018) in Table 2. Therefore, after
correcting for multiple testing our results remain significant at the 5% level using the sequential method.
As a robustness check we also include other studies that have overlapping, but significantly
longer sample periods. This expands the number of papers from two to eight. As noted earlier many of the
results in these six additional papers may not hold in our sample as they all use a significantly longer
sample period. For example, the investment results from Fresard and Valta (2016) do not hold in our
shorter sample which reduces the number of studies to seven. Only three of the remaining seven studies
were made available online before ours; the third one (the other two are mentioned above) is Zhang
(2016) which appeared in August 2016, but uses a longer sample period from 1974 to 2005. In this case

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the corrected critical value is 2.29 which implies that our result in column (3) of Table 2 (current vega

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with no control variables) is now only statistically significant at the 10% level. All the other results in
Table 2 continue to remain significant at the 5% using the corrected t-statistic from HRSW.

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The second method - the casual chain technique - stipulates that the most important hypotheses
as predicted by economic theory are examined first. For the first level of the causal chain we consider the
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direct effect of tariff cuts on competition. Next, the second level of the causal chain comprises the effect
of tariff cuts on corporate policies as this is the direct response of firms to the increase in competition.
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Finally, the third level of the causal chain comprises the effect of tariff cuts on outcome variables related
to the effect on parties outside the firm (e.g., analysts, customers etc.). How each paper fits in the causal
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chain is detailed in Table B.1. As we study how the firm changes its risk-incentive pay in response to
increases in competition, our study fits into the second tier of the causal chain. Both Flammer (2015) and
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Dasgupta et al. (2018), who look at the effect of tariffs cuts on corporate social responsibility (CSR) and
CEO turnover respectively, also fit into the second tier. This implies that one result (the effect of tariff
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cuts on competition) is prior to ours and other two results are conducted simultaneously (CSR and CEO
turnover) as they are in the same tier of the causal chain as our paper. With reference to Table 3 and
Figure 3 of HRSW, the adjusted critical t-statistic is 2.29. It follows that three of four results in our main
specifications in Table 2 remain significant at the 5% while the remaining result is significant at the 10%
level. 35
The third method, assumes that researchers conducted all tests simultaneously. This method has
some advantages over the sequential and causal chain methods. For instance, unlike the sequential method

35
If we include all papers with overlapping sample periods as ours there are 4 papers in the same causal chain tier as our paper.
In this case the adjusted t-statistic is 2.5 which implies that all our results in Table 2 are significant at the 10%, but not the 5%
level. As noted earlier this robustness test comes with the significant caveat that some of the previous results have much longer
sample periods and include many more tariff cuts and therefore may – like the result in Fresard and Valta (2016) - not hold in our
sample.
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it does not assume earlier studies are necessarily more important and unlike the causal chain method no
assumptions are made about which results are theoretically more important. On the other hand, the
simultaneous approach treats all prior results equally regardless of importance, increasing the bar for
significance for all results. In our case there are only two previous findings, resulting in an adjusted
critical t-statistic of 2.19. Thus, similar to the sequential method, all our main results in Table 2 remain
36
statistically significant at the 5% level.
Altogether, the sequential ordering, causal chain and simultaneous testing analysis all suggest that
our main finding of the causal effect of product market competition on the CEO risk incentive
compensation is unlikely to be a false discovery.

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B.2 Exclusion Restriction
HRSW also recommend reconciling the exclusion restriction with the rest of the literature that

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relies on the same experiment. The concern is that if researchers discover a natural experiment that
changes variable Y1 because it changes variable X, then, when another research team later examines the
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same setting, and finds a statistically significant result for variable Y2, the typical exclusion restriction
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states that the experiment affects Y2 only through X, but there is already evidence that Y1 changes too.
To verify the exclusion restriction of the tariff cuts instrument in light of the existing studies that use the
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same instrument we refer to the comprehensive survey of the literature discussed in section 4.8. Given the
evidence that the tariff cuts affect other corporate policies, it is possible that the effect on risk-incentive
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pay is, at least in part, due to these policy changes rather than being solely due to the increase in
competition. Moreover, if observable variables change in response to the tariff cuts it is also conceivable
that unobservable variables change too.
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We conduct the following analysis to increase our confidence that the exclusion restriction is
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likely to hold in our experimental setting. First, we perform a set of tests to directly rule out the
correlation between some of the aforementioned Y1 variables and CEO risk incentive compensation (our
Y2). To summarize briefly, we replace the dependent variable in our main specifications in Table 2 with
each of the Y1 variables. In Table D.4 in the Internet Appendix and Table 7 we show that there is no
change in sales, dividends, CEO compensation delta or CEO cash compensation around the tariff cut
shock. Second, we include some of the Y1 (e.g., investment, leverage etc.) as control variables in our
tests. This controls for any differential effect that the Y1 would have on our variable of interest: risk

36
A similar robustness check as in footnote 42 implies that there are seven previous findings that should be considered
simultaneously. This leads to an adjusted critical value of 2.68 (see Table 3 of HRSW). In this more stringent test, three out of
four results from our Table 2 continue to hold at the 10% level. The same caveat to this robustness tests as stated in footnote 42
continues to apply: papers that use much larger samples are essentially conducting different tests – and their results may not be
significant in our smaller sample.
 Journal Pre-proof

incentive-pay. Third, we argue that for some other variables (Y1) the channels through which the authors
claim competition affects these polices are theoretically unlikely to affect CEO option compensation (our
Y2). For example, an increase in corporate social responsibility (CSR) programs following intensified
competition is unlikely to have first order effect on CEO option compensation. Therefore, for this variable
(CSR) there does not seem to be persuasive evidence indicating that our main findings are explained by
changes in this variable.
Fourth, in some cases the channel through which enhanced competition affects the policy is
similar to what we find. For example, Valta (2012) argues that the increase in cost of bank debt caused by
the increase in competition is due to banks pricing financial contracts by taking into account increased
risk resulting from enhanced foreign competition. Here it is not only unlikely that this variable (i.e., cost

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of bank debt – Y1) directly affects CEO option compensation, but the proposed channel (i.e., the increase

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in risk) caused by enhanced foreign competition is consistent with the channel we document in our study.
The enhanced risk may induce the board to make adjustments in option compensation as we document

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and it may simultaneously be priced in bank loans which in turn increases the cost of bank debt as Valta
(2012) shows. This suggests that the increase in competition-induced risk could affect different polices in
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the corporation simultaneously (e.g., the cost of bank loans and CEO risk incentive compensation) as
these polices are all sensitive to changes in firm risk. Therefore, the competition induced increase in risk
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may lead to many risk related adjustments in firm policies at the same time (e.g., risk incentive pay and
the cost of debt) without necessarily preluding a causal interpretation for each individual affect.
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Similarly, trade shocks may have had other effects such as a decline of employment, increased
automation and the exit of firms in the affected industries. Although we cannot rule out that these factors
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rather than the increase in product market competition explain our results, it is likely that declines in
employment, increased automation, firm exit etc. are attributable at least in part to the trade-induced
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increase in product market competition in the firm’s industry. To the extent that this is true, our results are
still driven by increases in foreign competition but it gets harder to identify the exact channel through
which our results operate. For instance, we cannot untangle whether trade shocks increase product market
competition which leads to both reductions in risk-incentive pay and declines in employment, or
alternatively, if the increase in product market competition leads to declines in employment which in turn
reduces risk-incentive pay. This challenge - disentangling the channel through which shocks to
competition affect corporate policies - is a challenge shared with much of the literature. In sum, although
we cannot completely rule out that other factors besides the increase in competition contribute to
explaining our findings, the analysis above makes this less likely.
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Table B.1- List of Papers using the Tariff Cuts Experiment

This table lists research papers that use an experimental design that is similar to what we use in this paper: large tariffs cuts as a source of exogenous variation in
competition. To find these papers we look at all research papers on google.scholar that cited the two papers that arguably popularized the use of the tariff cuts
experiment in the finance literature: Valta (2012) and Fresard and Valta (2016). We restrict our search to papers that were cited at least once. We search for the
word ‘tariff’ in each paper and then read the relevant passage(s) to ascertain if and how the tariff cuts experiment is used in the paper. Synopsis is a very brief
summary of each paper’s findings related to the tariff experiment; Sample is the time period of tariff cuts that was used in the study; Available is the first time the
paper was available online; Source is the source where the paper was first found online. Methodology refers to the type of empirical methodology used – DID
stands for differences in differences, the length of the event window is in parenthesis and all the papers using a DID methodology use matching unless noted in

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the table. Causal Chain orders the papers by the importance of the hypothesis that is tested as suggested by Heath et al. (2021) – hereafter HRSW). The first
level of the causal chain is the direct effect of tariff cuts on competition; the second level of the causal chain are the effect of tariff cuts on corporate policies; the
third level of the causal chain is outcome variables related to the effect on parties outside the firm. Retest is equal to No (Yes) if the results of the paper do not

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hold (hold) using our sample and other methodology – N/A implies that we did not retest the results in the paper. This table lists the 15 papers (out of 35 total)
that are the closest to our study in regards to methodology and sample period. In Panel A are the two papers that use the same sample as we do and similar

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methodologies. In Panel B are papers that use larger sample periods, but similar methodologies. In Panel C lists papers that have non-overlapping samples with
our sample, but employ similar methodologies. In Panel D lists papers that use a staggered DID methodology as defined by HSRW.

r e Sam
Avai
labl
Causa
l
Re
tes

P
Authors Journal Synopsis ple e Source Methodology Chain t

l
Panel A: Similar dataset and methodology
1992

a
Strategic Management Tariff cuts => increase engagement in Corporate Social Sep- N/
Flammer (2015) - SSRN DID (3 years) 2
Journal Responsibility (CSR) 12 A

rn
2005
1992
Dasgupta, Li and Review of Financial Tariff cuts => increase the likelihood of forced CEO turnover and Dec- N/
- SSRN DID (3 years) 2
Wang (2018) Studies its sensitivity to performance

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14 A
2005

Panel B: Larger datasets, similar methodology

Fresard and Valta
(2016)
Review of Corporate
Finance Studies J o
Tariff cuts => reduce firm investment
1974
-
2005
Mar-
12
SSRN DID (1 year) 2 No

1974
Aug N/
Zhang (2016) Working Paper Tariff cuts => changes in business strategy - SSRN DID (2 years) 2
-16 A
2005
Bakke, Feng, 1992 Date
Dec- N/
Mahmudi and Zhu Working Paper Tariff cuts => reduce CEO risk-incentive pay - present DID (2 years) 2
16 A
(2021) 2005 ed
1974
Morellec and Review of Financial Feb- DID (3 years) N/
Tariff cuts => decrease in option skewness - SSRN 3
Zhdanov (2019) Studies 17 - no matching A
2005
Mattei and Review of Accounting Tariff cuts: decrease analyst forecast precision 1974 Apr- SSRN DID (1 and 2 3 N/
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Platikanova (2017) Studies - 17 years) A

2005
Review of Quantitative 1989
Burke, Eaton and Oct- Publish N/
Finance and Tariff cuts => more accounting conservatism - DID (2 years) 2
Wang (2019) 18 ed A
Accounting 2011
1984
Lee and Wen Journal of International Nov Publish N/
Tariff cuts => less analyst coverage - DID 3
(2020) Financial Management -19 ed A
2005

Panel C: Non-overlapping samples, similar methodology

Chen and Wu
Working Paper
Tariff cuts => more innovation (more patents, more patent

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1996
Aug
SSRN DID (3 years) 2
N/

o
(2019) citations) -19 A
2006

Lin and Wei (2014) Working Paper

Tariff cuts => less voluntary disclosure, short horizon of
disclosure, less precise disclosure

p r 1995
-
Aug
-14
SSRN
DID (1 years)
- no matching
2
N/
A

-
2005
1990

e
Aug N/
Li and Zhan (2019) Management Science Tariff cuts => increase in firms’ stock price crash risk. - SSRN DID (3 years) 3

r
-14 A
1998

Panel D: Staggered DID

l P 1994

a
Huang, Jennings Tariff cuts => decrease in management forecasts of annual Jul- N/
Accounting Review - SSRN Staggered 2
and Yu (2017) earnings 16 A

rn
2011
1974
Journal of Financial Oct- N/
Valta (2012) Tariff cuts => increase in the cost of bank debt - SSRN Staggered 3

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Economics 09 A
2005

o
1981
Giannetti and Yu Tariff cuts => drops in sales and increased bankruptcy. Firms with May
Management Science - SSRN Staggered 2 No

J
(2021) more short term investors adapt better to increases in competition. -17
2005
1975
Grullon, Larkin and Mar-
Working Paper Tariff cuts => higher dividends - SSRN Staggered 2 No
Michaely (2019) 07
2006
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Foreign Competition and CEO Risk-Incentive Compensation

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Tor-Erik Bakke37, Felix Zhiyu Feng, Hamed Mahmudi, and Caroline H. Zhu

June, 2022
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Abstract

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How do firms modify CEO risk-incentive compensation in response to increased foreign competition? Theoretically we show

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the answer is ambiguous: increased competition can result in firms either increasing or decreasing the CEO’s risk-taking
incentives. Empirically using a quasi-natural experiment, tariff cuts resulting from important trade deals, we find evidence

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that in response to increases in foreign competition firms adjust CEO risk-incentive compensation downwards – a result that
is more pronounced for firms with less risk-averse CEOs. These findings suggest that more intense foreign competition
results in managers voluntarily taking on more risk, and firms therefore reduce the convexity in managers’ compensation.

37 Corresponding author. Phone: 608-770-7753. Email: tbakke@uic.edu


Bakke (tbakke@uic.edu) is at the University of Illinois at Chicago. Feng (ffeng@uw.edu) is at the University of Washington. Mahmudi (hmahmudi@udel.edu)
is at the University of Delaware. Zhu (cz19@spu.edu) is at Seattle Pacific University. We are grateful to Daniel Hungerman, Janya Golubeva, Peter MacKay,
Bill Megginson, Mehdi Mohseni, Pradeep Yadav, and seminar participants at MFA, University of Notre Dame, and University of Oklahoma for helpful
comments. Jeff Black, Karim Farroukh, Fang Lin and Kelly Zhang provided excellent research assistance.