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The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts

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  • Pierre Chaigneau
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    Abstract

    We 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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    File URL: http://www.cirpee.org/fileadmin/documents/Cahiers_2012/CIRPEE12-09.pdf
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    Bibliographic Info

    Paper provided by CIRPEE in its series Cahiers de recherche with number 1209.

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    Date of creation: 2012
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    Handle: RePEc:lvl:lacicr:1209

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    Related research

    Keywords: Executive compensation; principal-agent model; prudence; risk preferences; stock-options;

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    References

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    1. Stephen A. Ross, 2004. "Compensation, Incentives, and the Duality of Risk Aversion and Riskiness," Journal of Finance, American Finance Association, vol. 59(1), pages 207-225, 02.
    2. Kraus, Alan & Litzenberger, Robert H, 1976. "Skewness Preference and the Valuation of Risk Assets," Journal of Finance, American Finance Association, vol. 31(4), pages 1085-1100, September.
    3. Sanford Grossman & Oliver Hart, . "An Analysis of the Principal-Agent Problem," Rodney L. White Center for Financial Research Working Papers 15-80, Wharton School Rodney L. White Center for Financial Research.
    4. Pierre-Olivier Gourinchas & Jonathan A. Parker, 2001. "The Empirical Importance of Precautionary Saving," American Economic Review, American Economic Association, vol. 91(2), pages 406-412, May.
    5. Brian J. Hall & Kevin J. Murphy, 2000. "Stock Options for Undiversified Executives," NBER Working Papers 8052, National Bureau of Economic Research, Inc.
    6. 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.
    7. Scott, Robert C & Horvath, Philip A, 1980. " On the Direction of Preference for Moments of Higher Order Than the Variance," Journal of Finance, American Finance Association, vol. 35(4), pages 915-19, September.
    8. W Henry Chiu, 2010. "Skewness Preference, Risk Taking and Expected Utility Maximisation," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 35(2), pages 108-129, December.
    9. Maug, Ernst & Dittmann, Ingolf, 2007. "Lower Salaries and No Options: The Optimal Structure of Executive Pay," Sonderforschungsbereich 504 Publications 07-41, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
    10. Martin Browning & Annamaria Lusardi, 1996. "Household Saving: Micro Theories and Micro Facts," Journal of Economic Literature, American Economic Association, vol. 34(4), pages 1797-1855, December.
    11. Ingolf Dittmann & Ko-Chia Yu, 2009. "How Important Are Risk-Taking Incentives in Executive Compensation?," Tinbergen Institute Discussion Papers 09-076/2, Tinbergen Institute.
    12. Ingolf Dittmann & Ernst Maug & Oliver Spalt, 2010. "Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse," Journal of Finance, American Finance Association, vol. 65(6), pages 2015-2050, December.
    13. Brian J. Hall & Kevin J. Murphy, 2000. "Optimal Exercise Prices for Executive Stock Options," NBER Working Papers 7548, National Bureau of Economic Research, Inc.
    14. Jenter, Dirk, 2004. "Executive Compensation, Incentives, and Risk," Working papers 4466-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    15. Keenan, Donald C. & Snow, Arthur, 2010. "Greater prudence and greater downside risk aversion," Journal of Economic Theory, Elsevier, vol. 145(5), pages 2018-2026, September.
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