The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts
AbstractWe use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by risk averse managers, in a fairly general setting. We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. This is because concave contracts concentrate incentives where the marginal utility of risk averse managers is highest, while convex contracts protect against downside risk. Thus, prudence can contribute to explain the prevalence of stock-options in executive compensation. We also present a condition on the utility function which enables to compare the structure of optimal contracts associated with different risk preferences.
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Bibliographic InfoPaper provided by CIRPEE in its series Cahiers de recherche with number 1209.
Date of creation: 2012
Date of revision:
Executive compensation; principal-agent model; prudence; risk preferences; stock-options;
Find related papers by JEL classification:
- 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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