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The Valuation of Assets under Moral Hazard

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Author Info
Ram T. S. Ramakrishnan (Sloan School of Management, M.I.T.)
Anjan V. Thakor (Washington University in St. Louis)

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Abstract

The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of manages can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms.

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Paper provided by EconWPA in its series Finance with number 0411032.

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Date of creation: 11 Nov 2004
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Handle: RePEc:wpa:wuwpfi:0411032

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G - Financial Economics

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October. [Downloadable!] (restricted)
  2. Ram T. S. Ramakrishnan & Anjan V. Thakor, 2004. "Moral Hazard, Agency Costs, and Asset Prices in a Competitive Equilibrium," Finance 0411033, EconWPA. [Downloadable!]
  3. Diamond, Douglas W & Verrecchia, Robert E, 1982. " Optimal Managerial Contracts and Equilibrium Security Prices," Journal of Finance, American Finance Association, vol. 37(2), pages 275-87, May. [Downloadable!] (restricted)
  4. Gur Huberman & Zhenyu Wang, 2005. "Arbitrage pricing theory," Staff Reports 216, Federal Reserve Bank of New York. [Downloadable!]
  5. Harris, Milton & Raviv, Artur, 1979. "Optimal incentive contracts with imperfect information," Journal of Economic Theory, Elsevier, vol. 20(2), pages 231-259, April. [Downloadable!] (restricted)
  6. James A. Mirrlees, 1976. "The Optimal Structure of Incentives and Authority Within an Organization," Bell Journal of Economics, The RAND Corporation, vol. 7(1), pages 105-131, Spring. [Downloadable!] (restricted)
  7. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring. [Downloadable!] (restricted)
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  1. Paul K. Chaney & Anjan V. Thakor, 2004. "Incentive Effects of Benevolent Intervention - The case of government loan guarantees," Finance 0411047, EconWPA. [Downloadable!]
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