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Uncertainty, risk, and incentives: theory and evidence

  • Zhiguo He
  • Si Li
  • Bin Wei
  • Jianfeng Yu
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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.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2013-18.

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Date of creation: 2013
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Handle: RePEc:fip:fedgfe:2013-18
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  1. Edmans, Alex & Gabaix, Xavier, 2010. "Tractability in Incentive Contracting," Working Papers 10-13, University of Pennsylvania, Wharton School, Weiss Center.
  2. Zabojnik, Jan, 1996. "Pay-performance sensitivity and production uncertainty," Economics Letters, Elsevier, vol. 53(3), pages 291-296, December.
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  5. Bo Becker, 2006. "Wealth and Executive Compensation," Journal of Finance, American Finance Association, vol. 61(1), pages 379-397, 02.
  6. Martijn Cremers & Hongjun Yan, 2009. "Uncertainty and Valuations," Yale School of Management Working Papers amz2383, Yale School of Management, revised 01 May 2009.
  7. Joseph G. Haubrich, 1991. "Risk aversion, performance pay, and the principal-agent problem," Working Paper 9118, Federal Reserve Bank of Cleveland.
  8. 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.
  9. Xavier Gabaix & Augustin Landier, 2006. "Why Has CEO Pay Increased So Much?," NBER Working Papers 12365, National Bureau of Economic Research, Inc.
  10. John R. Graham & Si Li & Jiaping Qiu, 2011. "Managerial Attributes and Executive Compensation," NBER Working Papers 17368, National Bureau of Economic Research, Inc.
  11. 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.
  12. 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, 02.
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