Traditional agency theory treats risk as pure measurement error, yielding the standard prediction of risk-incentive tradeoff. This paper proposes a model in which the agent can respond to risk: he can exert effort to collect information about the underlying state in order to make correct decisions. Such effort is thus more valuable in a riskier environment, and the implication is that incentives can increase with the risk that the agent can respond to. Moreover, since the agent makes investment decisions based on the collected information about the state, the variability of investments increases with “respondable” risk. I test the model using data on CEOs. Market-wide risk is used to capture more risk for which CEOs’ effort is not particularly valuable, and industry- and firm-specific risk are used to represent more “respondable” risk. I find that incentives for CEOs decrease with the former and increase with the latter. As the definition of the industry is broadened, the positive relation between incentives and industry-specific risk diminishes. I also find empirical support for the prediction that the variability of firms’ investments increases with “respondable” risk.
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Paper provided by University of Washington, Department of Economics in its series Working Papers with number
UWEC-2004-19.