Are relative performance measures in CEO incentive contracts used for risk reduction and/or strategic interaction

A long stream of accounting research examines the use of relative performance evaluation (RPE) in CEO incentive contracting in order to remove industry-wide risk factors as predicted by agency theory. My dissertation examines whether RPE has the additional role of motivating strategic interaction between own-firm and peer-firm managers, as industrial organization theory predicts, and whether the two objectives of RPE are mutually exclusive. Using data from the U.S. airline industry, I first document empirical support for the strong-form (but not the weak-form) RPE hypothesis, suggesting that firms entirely remove noise from relative performance measures. Importantly, I further hypothesize and find that CEO pay-for-peer-group-performance sensitivity is negative (positive) when firms compete in strategic substitutes (complements), indicating that RPE has directionally opposite effects on CEO incentives (depending on the type of strategic competition) that cancel each other in aggregate. This result explains the lack of support for the weak-form RPE hypothesis. However, the information and strategic objectives of RPE are not mutually exclusive. I hypothesize and find that firms filter out common risk from CEO incentive contracts by removing the systematic (i.e., common) component of performance and use the unsystematic (i.e., unique) component of performance to influence strategic interaction. This dissertation suggests that firms provide managerial incentives that are contingent on their own and peer firms' performance in order to both influence strategic interaction with peer firms and reduce the risk placed on their own managers.