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The Valuation of Assets under Moral Hazard

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  • Ramakrishnan, Ram T S
  • Thakor, Anjan V

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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  • Ramakrishnan, Ram T S & Thakor, Anjan V, 1984. "The Valuation of Assets under Moral Hazard," Journal of Finance, American Finance Association, vol. 39(1), pages 229-238, March.
    • Handle: RePEc:bla:jfinan:v:39:y:1984:i:1:p:229-38
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    2. Nagarajan, S. & Sealey, C. W., 1995. "Forbearance, deposit insurance pricing, and incentive compatible bank regulation," Journal of Banking & Finance, Elsevier, vol. 19(6), pages 1109-1130, September.
    3. Charles Calomiris, 1995. "The Costs of Rejecting Universal Banking: American Finance in the German Mirror, 1870-1914," NBER Chapters, in: Coordination and Information: Historical Perspectives on the Organization of Enterprise, pages 257-322, National Bureau of Economic Research, Inc.
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    10. Szilagyi, P.G., 2007. "Corporate governance and the agency costs of debt and outside equity," Other publications TiSEM 9520d40a-224f-43a8-9bf9-b, Tilburg University, School of Economics and Management.

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