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Reward for Luck in a Dynamic Agency Model


  • Florian Hoffmann
  • Sebastian Pfeil


This article studies a continuous time principal-agent problem of a firm whose cash flows are determined by the manager's unobserved effort. The firm's cash flows are further subject to persistent and publicly observable shocks that are beyond the manager's control. While standard contracting models predict that compensation should optimally filter out these shocks, empirical evidence suggests otherwise. In line with this evidence, our model predicts that the manager is "rewarded for luck." The Author 2010. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail:, Oxford University Press.

Suggested Citation

  • Florian Hoffmann & Sebastian Pfeil, 2010. "Reward for Luck in a Dynamic Agency Model," Review of Financial Studies, Society for Financial Studies, vol. 23(9), pages 3329-3345.
  • Handle: RePEc:oup:rfinst:v:23:y:2010:i:9:p:3329-3345

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    References listed on IDEAS

    1. Andrew B. Abel & Janice C. Eberly, 1996. "Optimal Investment with Costly Reversibility," Review of Economic Studies, Oxford University Press, vol. 63(4), pages 581-593.
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    5. Ivo Welch, 2004. "Capital Structure and Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 112(1), pages 106-131, February.
    6. Lu Zhang, 2005. "The Value Premium," Journal of Finance, American Finance Association, vol. 60(1), pages 67-103, February.
    7. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    8. Fischer, Edwin O & Heinkel, Robert & Zechner, Josef, 1989. " Dynamic Capital Structure Choice: Theory and Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 19-40, March.
    9. Robert E. Hall, 2004. "Measuring Factor Adjustment Costs," The Quarterly Journal of Economics, Oxford University Press, vol. 119(3), pages 899-927.
    10. Ilan Cooper, 2006. "Asset Pricing Implications of Nonconvex Adjustment Costs and Irreversibility of Investment," Journal of Finance, American Finance Association, vol. 61(1), pages 139-170, February.
    11. Black, Fischer, 1972. "Capital Market Equilibrium with Restricted Borrowing," The Journal of Business, University of Chicago Press, vol. 45(3), pages 444-455, July.
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    Cited by:

    1. Keiichi Hori & Hiroshi Osano, 2013. "Managerial Incentives and the Role of Advisors in the Continuous-Time Agency Model," Review of Financial Studies, Society for Financial Studies, vol. 26(10), pages 2620-2647.
    2. Katolnik, Svetlana & Schöndube, Jens Robert, 2015. "Don't Kill the Goose that Lays the Golden Eggs: Strategic Delay in Project Completion," Annual Conference 2015 (Muenster): Economic Development - Theory and Policy 113046, Verein für Socialpolitik / German Economic Association.
    3. Pagès, Henri, 2013. "Bank monitoring incentives and optimal ABS," Journal of Financial Intermediation, Elsevier, vol. 22(1), pages 30-54.
    4. Katolnik, Svetlana & Schöndube, Jens Robert, 2014. "Don't Kill the Goose that Lays the Golden Eggs: Strategic Delay in Project Completion," Hannover Economic Papers (HEP) dp-533, Leibniz Universität Hannover, Wirtschaftswissenschaftliche Fakultät.
    5. Pierre Chaigneau & Nicolas Sahuguet, "undated". "The structure of CEO pay: pay-for-luck and stock-options," FMG Discussion Papers dp713, Financial Markets Group.
    6. repec:eee:jbfina:v:82:y:2017:i:c:p:40-58 is not listed on IDEAS
    7. repec:eee:mateco:v:71:y:2017:i:c:p:74-91 is not listed on IDEAS
    8. Anderson, Ronald W. & Bustamante, Maria Cecilia & Guibaud, Stéphane & Zervos, Mihail, 2017. "Agency, firm growth, and managerial turnover," LSE Research Online Documents on Economics 68784, London School of Economics and Political Science, LSE Library.
    9. Grochulski, Borys & Wong, Russell & Zhang, Yuzhe, 2017. "Optimal Incentive Contracts with Job Destruction Risk," Working Paper 17-11, Federal Reserve Bank of Richmond.
    10. repec:eee:joepsy:v:62:y:2017:i:c:p:87-97 is not listed on IDEAS
    11. Brett Green & Curtis R. Taylor, 2016. "Breakthroughs, Deadlines, and Self-Reported Progress: Contracting for Multistage Projects," American Economic Review, American Economic Association, vol. 106(12), pages 3660-3699, December.
    12. Liu, Bo & Mu, Congming & Yang, Jinqiang, 2017. "Dynamic agency and investment theory with time-inconsistent preferences," Finance Research Letters, Elsevier, vol. 20(C), pages 88-95.
    13. Jonathan Wiley & Brandon Cline & Xudong Fu & Tian Tang, 2012. "Valuation Effects for Asset Sales," Journal of Financial Services Research, Springer;Western Finance Association, vol. 41(3), pages 103-120, June.
    14. Pagès, H., 2009. "Bank incentives and optimal CDOs," Working papers 253, Banque de France.
    15. li, Hong & Mu, Congming & Yang, Jinqiang, 2016. "Optimal contract theory with time-inconsistent preferences," Economic Modelling, Elsevier, vol. 52(PB), pages 519-530.
    16. Hiroshi Osano & Keiichi Hori, 2015. "A Dynamic Agency Theory of Investment and Managerial Replacement," KIER Working Papers 921, Kyoto University, Institute of Economic Research.
    17. Hengjie Ai & Rui Li, 2012. "Moral hazard, investment, and firm dynamics," FRB Atlanta CQER Working Paper 2012-01, Federal Reserve Bank of Atlanta.

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