Recent studies in macroeconomics and finance have emphasized a strong negative relationship between uncertainty shocks and capital investment policies. Theoretical explanations for the response of investment to changes in idiosyncratic volatility have traditionally focused on the real option feature of investment. With costly reversibility, an increase in volatility changes the optimal timing of investment. Following the financial crisis of 2007–2009, researchers explored imperfections in financial markets as a potential mechanism that generates the observed link between uncertainty and investment.
My colleague Brent Glover, of the Tepper School of Business at Carnegie Mellon University, and I investigated the role of an agency conflict between a firm’s manager and shareholders in explaining the relationship between uncertainty and investment. Increasingly, compensation contracts for executives of U.S. public firms consist largely of own-company stock and options. These contracts expose a manager to firm-specific risk, which is not borne by diversified shareholders. This drives a wedge between the pricing kernels, and therefore optimal investment policies, of a firm’s manager and diversified shareholders. If shareholders are unable to perfectly monitor managers, firm investment policies are likely to reflect the manager incentives induced by the compensation contract. Importantly, the manager’s optimal response to an uncertainty shock will depend on the structure of his or her incentive-based compensation contract.
This agency conflict is important in understanding the response of investment to volatility shocks. To quantify the investment incentives of the manager, we developed a model of firm investment that embeds an agency conflict between the manager and outside shareholders. In the model, firms are operated by managers who are compensated with their own company’s stock and options, in addition to a fixed salary. Thus, the model explicitly links manager compensation contracts to optimal firm investment policies and provides predictions for the relationship between idiosyncratic volatility shocks, the compensation contract, and a manager’s optimal investment policy.
The model predicts a conditional relationship between firm-specific uncertainty and investment that can vary across firms and over time. We show that an increase in firm-specific uncertainty can incentivize a manager to either increase or decrease firm investment, where the sign and magnitude of the response depend on the structure of the compensation contract.
We use a large panel of firm-level compensation data to calibrate the model and compute the optimal investment response to a volatility shock. We do this for each firm-year in our sample and compare this panel of estimated manager investment incentives to the investment policies that would be optimal for a diversified shareholder.
The panel of predicted manager investment responses to volatility shocks, which are estimated from the model, exhibit significant cross-sectional and time series variation. Moreover, we show that the predicted manager responses have strong predictive power for firms’ observed investment responses to volatility shocks in the data. In particular, we find that the documented negative relationship between volatility and investment is only present for those firms that provide compensation contracts that predict this negative response. Taken together, our results suggest that understanding the structure of executive compensation contracts is important for understanding the link between uncertainty and investment observed in the data.
We found evidence that manager incentives are important for understanding a firm’s investment response to changes in volatility, which suggests that future research should consider the impact of delegated control and agency conflicts when studying the relationship between uncertainty and investment.