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Entrepreneurial Incentives in Stock Market Economies

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Author Info
Acharya, Viral V
Bisin, Alberto

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Abstract

A Capital Asset Pricing Model of a stock market economy is examined under different corporate governance structures in which the objectives of managers and entrepreneurs in choosing the risk composition of their firms' returns are not aligned with those of shareholders and investors because of moral hazard. It is shown that incentive compensation, by exposing managers and entrepreneurs to unhedgeable firm-specific risk, induces them to change the stochastic properties of firm cash flows. Since they can trade in markets for aggregate risk but not for firm-specific risk, managers and entrepreneurs produce excessive aggregate risk compared to the first-best allocation. This results in a diversification externality for the stock market investors who cannot share the aggregate risks amongst each other as well as they can the firm-specific risks. The optimal incentive compensation designed to address such diversification externality is fully characterized and it is demonstrated that financial markets interact with the stock market in important ways in determining the effectiveness of incentive contracts in controlling the negative welfare effects of diversification externality.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3474.

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Date of creation: Jul 2002
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Handle: RePEc:cpr:ceprdp:3474

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Related research
Keywords: aggregate risk; CAPM; entrepreneurship; financial innovation; hedging; idiosyncratic risk; managerial incentives; stock market efficiency;

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Find related papers by JEL classification:
D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
D62 - Microeconomics - - Welfare Economics - - - Externalities
G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Investment Policy
G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure
J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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