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Uncertainty, Risk, and Incentives: Theory and Evidence

Listed author(s):
  • Zhiguo He

    ()

    (Booth School of Business, University of Chicago, Chicago, Illinois 60637)

  • Si Li

    ()

    (School of Business and Economics, Wilfrid Laurier University, Waterloo, Ontario N2L 3C5, Canada; and PBC School of Finance, Tsinghua University, 100083 Beijing, China)

  • Bin Wei

    ()

    (Board of Governors of the Federal Reserve System, Washington, DC 20551)

  • Jianfeng Yu

    ()

    (Carlson School of Management, University of Minnesota, Minneapolis, Minnesota 55455)

Registered author(s):

Uncertainty has qualitatively different implications than risk in studying executive incentives. We study the interplay between profitability uncertainty and moral hazard, where profitability is multiplicative with managerial effort. Investors who face greater uncertainty desire faster learning, and consequently offer higher managerial incentives to induce higher effort from the manager. In contrast to the standard negative risk-incentive trade-off, this “learning-by-doing” effect generates a positive relation between profitability uncertainty and incentives. We document empirical support for this prediction. This paper was accepted by Wei Jiang, finance.

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File URL: http://dx.doi.org/10.1287/mnsc.2013.1744
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Article provided by INFORMS in its journal Management Science.

Volume (Year): 60 (2014)
Issue (Month): 1 (January)
Pages: 206-226

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Handle: RePEc:inm:ormnsc:v:60:y:2014:i:1:p:206-226
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  1. Alex Edmans & Xavier Gabaix, 2011. "Tractability in Incentive Contracting," Review of Financial Studies, Society for Financial Studies, vol. 24(9), pages 2865-2894.
  2. Xavier Gabaix & Augustin Landier, 2008. "Why has CEO Pay Increased So Much?," The Quarterly Journal of Economics, Oxford University Press, vol. 123(1), pages 49-100.
  3. Haubrich, Joseph G, 1994. "Risk Aversion, Performance Pay, and the Principal-Agent Problem," Journal of Political Economy, University of Chicago Press, vol. 102(2), pages 258-276, April.
  4. Bo Becker, 2006. "Wealth and Executive Compensation," Journal of Finance, American Finance Association, vol. 61(1), pages 379-397, February.
  5. Jovanovic, Boyan & Prat, Julien, 2010. "Dynamic Incentive Contracts under Parameter Uncertainty," CEPR Discussion Papers 8136, C.E.P.R. Discussion Papers.
  6. Jovanovic, Boyan & Prat, Julien, 2014. "Dynamic contracts when agent's quality is unknown," Theoretical Economics, Econometric Society, vol. 9(3), September.
  7. 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, February.
  8. Zabojnik, Jan, 1996. "Pay-performance sensitivity and production uncertainty," Economics Letters, Elsevier, vol. 53(3), pages 291-296, December.
  9. John R. Graham & Si Li & Jiaping Qiu, 2011. "Managerial Attributes and Executive Compensation," NBER Working Papers 17368, National Bureau of Economic Research, Inc.
  10. Alex Edmans & Xavier Gabaix, 2011. "The Effect of Risk on the CEO Market," Review of Financial Studies, Society for Financial Studies, vol. 24(8), pages 2822-2863.
  11. Martijn Cremers & Hongjun Yan, 2009. "Uncertainty and Valuations," Yale School of Management Working Papers amz2383, Yale School of Management, revised 01 May 2009.
  12. Marianne P. Bitler & Tobias J. Moskowitz & Annette Vissing-Jørgensen, 2005. "Testing Agency Theory with Entrepreneur Effort and Wealth," Journal of Finance, American Finance Association, vol. 60(2), pages 539-576, April.
  13. Alex Edmans & Xavier Gabaix & Augustin Landier, 2009. "A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium," Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 4881-4917, December.
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