Risk Taking of Executives under Different Incentive Contracts: Experimental Evidence
AbstractClassic financial agency theory recommends compensation through stock options rather than shares to induce risk neutrality in otherwise risk averse agents. In an experiment, we find that subjects acting as executives do also take risks that are excessive from the perspective of shareholders if compensated through options. Compensation through restricted company stock reduces the uptake of excessive risks. Even under stock-ownership, however, experimental executives continue to take excessive risks—a result that cannot be accounted for by classic incentive theory. We develop a basic model in which such risk-taking behavior is explained based on a richer array of risk attitudes derived from Prospect Theory. We use the model to derive hypotheses on what may be driving excessive risk taking in the experiment. Testing those hypotheses, we find that most of them are indeed borne out by the data. We thus conclude that a prospect-theory-based model is more apt at explaining risk attitudes under different compensation regimes than traditional principal-agent models grounded in expected utility theory.
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Bibliographic InfoPaper provided by University of Munich, Department of Economics in its series Discussion Papers in Economics with number 12210.
Date of creation: Apr 2011
Date of revision:
prospect theory; expected utility theory; risk attitude; executive compensation; reference dependence; experimental finance;
Find related papers by JEL classification:
- D03 - Microeconomics - - General - - - Behavioral Microeconomics; Underlying Principles
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
- L22 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Organization and Market Structure
This paper has been announced in the following NEP Reports:
- NEP-ALL-2011-04-23 (All new papers)
- NEP-CBE-2011-04-23 (Cognitive & Behavioural Economics)
- NEP-EXP-2011-04-23 (Experimental Economics)
- NEP-UPT-2011-04-23 (Utility Models & Prospect Theory)
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