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Prudence and the convexity of compensation contracts

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  • Chaigneau, Pierre
  • Sahuguet, Nicolas
  • Sinclair-Desgagné, Bernard

Abstract

In a standard principal–agent model, we derive a new condition that relates the structure of the optimal contract to the agent’s risk preferences: The optimal contract is more convex than the likelihood ratio of the performance measure if and only if the coefficient of absolute prudence is larger than twice the coefficient of absolute risk aversion. With CRRA utility, this condition is satisfied if and only if relative risk aversion is less than one.

Suggested Citation

  • Chaigneau, Pierre & Sahuguet, Nicolas & Sinclair-Desgagné, Bernard, 2017. "Prudence and the convexity of compensation contracts," Economics Letters, Elsevier, vol. 157(C), pages 14-16.
    • Handle: RePEc:eee:ecolet:v:157:y:2017:i:c:p:14-16
    DOI: 10.1016/j.econlet.2017.05.014
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    Cited by:

    1. Pierre Chaigneau & Alex Edmans & Daniel Gottlieb, 2022. "How Should Performance Signals Affect Contracts?," Review of Financial Studies, Society for Financial Studies, vol. 35(1), pages 168-206.

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    More about this item

    Keywords

    Executive compensation; Principal–agent model; Prudence; Risk aversion;
    All these keywords.

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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