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Uncertainty, risk, and incentives: theory and evidence

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

Abstract

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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  • Zhiguo He & Si Li & Bin Wei & Jianfeng Yu, 2013. "Uncertainty, risk, and incentives: theory and evidence," Finance and Economics Discussion Series 2013-18, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgfe:2013-18
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    6. Zhihua Chen & Yanfei Lan & Ruiqing Zhao, 2018. "Impacts of risk attitude and outside option on compensation contracts under different information structures," Fuzzy Optimization and Decision Making, Springer, vol. 17(1), pages 13-47, March.
    7. Pu Chen & Sanxi Li & Jianye Yan & Xundong Yin, 2016. "Moral hazard in innovation: the relationship between risk aversion and performance pay," Journal of Economics, Springer, vol. 118(1), pages 77-89, May.
    8. Peng, Lin & Röell, Ailsa A & Tang, Hongfei, 2016. "CEO Incentives: Measurement, Determinants, and Impact on Performance," CEPR Discussion Papers 11417, C.E.P.R. Discussion Papers.
    9. Cintya Lanchimba & Josef Windsperger & Muriel Fadairo, 2018. "Entrepreneurial orientation, risk and incentives: the case of franchising," Small Business Economics, Springer, vol. 50(1), pages 163-180, January.

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