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.
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Working papers
WP 2062-88., Massachusetts Institute of Technology (MIT), Sloan School of Management.
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