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Uncertainty, risk, and incentives: theory and evidence

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  • Zhiguo He
  • Si Li
  • Bin Wei
  • Jianfeng Yu
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    Abstract

    Uncertainty has qualitatively different implications than risk in studying executive incentives. We study the interplay between profitability uncertainty and moral hazard, where profitability is multiplicative with managerial effort. Investors who face greater uncertainty desire faster learning, and consequently offer higher managerial incentives to induce higher effort from the manager. In contrast to the standard negative risk-incentive trade-off, this "learning-by-doing" effect generates a positive relation between profitability uncertainty and incentives. We document empirical support for this prediction.

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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2013-18.

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    Date of creation: 2013
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    Handle: RePEc:fip:fedgfe:2013-18

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    1. John R. Graham & Si Li & Jiaping Qiu, 2011. "Managerial Attributes and Executive Compensation," NBER Working Papers 17368, National Bureau of Economic Research, Inc.
    2. Jovanovic, Boyan & Prat, Julien, 2010. "Dynamic Incentive Contracts under Parameter Uncertainty," CEPR Discussion Papers 8136, C.E.P.R. Discussion Papers.
    3. Martijn Cremers & Hongjun Yan, 2009. "Uncertainty and Valuations," Yale School of Management Working Papers amz2383, Yale School of Management, revised 01 May 2009.
    4. Xavier Gabaix & Augustin Landier, 2008. "Why Has CEO Pay Increased So Much?," The Quarterly Journal of Economics, MIT Press, vol. 123(1), pages 49-100, 02.
    5. Alex Edmans & Xavier Gabaix, 2011. "The Effect of Risk on the CEO Market," Review of Financial Studies, Society for Financial Studies, vol. 24(8), pages 2822-2863.
    6. Bo Becker, 2006. "Wealth and Executive Compensation," Journal of Finance, American Finance Association, vol. 61(1), pages 379-397, 02.
    7. Ingolf Dittmann & Ernst Maug, 2007. "Lower Salaries and No Options? On the Optimal Structure of Executive Pay," Journal of Finance, American Finance Association, vol. 62(1), pages 303-343, 02.
    8. Zabojnik, Jan, 1996. "Pay-performance sensitivity and production uncertainty," Economics Letters, Elsevier, vol. 53(3), pages 291-296, December.
    9. Alex Edmans & Xavier Gabaix, 2009. "Tractability in Incentive Contracting," NBER Working Papers 15545, National Bureau of Economic Research, Inc.
    10. Alex Edmans & Xavier Gabaix & Augustin Landier, 2009. "A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 4881-4917, December.
    11. Marianne P. Bitler & Tobias J. Moskowitz & Annette Vissing-Jørgensen, 2005. "Testing Agency Theory with Entrepreneur Effort and Wealth," Journal of Finance, American Finance Association, vol. 60(2), pages 539-576, 04.
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