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Stock Market Tournaments

  • Emre Ozdenoren

    ()

    (London Business School and CEPR)

  • Kathy Yuan

    ()

    (London School of Economics and CEPR)

We propose a new theory of suboptimal risk-taking based on contractual externalities. We examine an industry with a continuum of firms. Each firm's manager exerts costly hidden effort. The productivity of effort is subject to systematic shocks. Firms' stock prices reflect their performance relative to the industry average. In this setting, stock-based incentives cause complementarities in managerial effort choices. Externalities arise because shareholders do not internalize the impact of their incentive provision on the average effort. During booms, they over-incentivise managers, triggering a rat-race in effort exertion, resulting in excessive risk relative to the second-best. The opposite occurs during busts.

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File URL: http://eaf.ku.edu.tr/sites/eaf.ku.edu.tr/files/erf_wp_1222.pdf
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Paper provided by Koc University-TUSIAD Economic Research Forum in its series Koç University-TUSIAD Economic Research Forum Working Papers with number 1222.

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Length: 45 pages
Date of creation: Aug 2012
Date of revision:
Handle: RePEc:koc:wpaper:1222
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  1. Green, Jerry R & Stokey, Nancy L, 1983. "A Comparison of Tournaments and Contracts," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 349-64, June.
  2. Da, Zhi & Schaumburg, Ernst, 2011. "Relative valuation and analyst target price forecasts," Journal of Financial Markets, Elsevier, vol. 14(1), pages 161-192, February.
  3. Palomino, Frederic & Prat, Andrea, 2003. " Risk Taking and Optimal Contracts for Money Managers," RAND Journal of Economics, The RAND Corporation, vol. 34(1), pages 113-37, Spring.
  4. Guillaume Plantin & Igor Makarov, 2010. "Rewarding Trading Skills Without Inducing Gambling," 2010 Meeting Papers 899, Society for Economic Dynamics.
  5. Peter Diamond, 1998. "Managerial Incentives: On the Near Linearity of Optimal Compensation," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 931-957, October.
  6. Ing-Haw Cheng & Harrison Hong & Jose A. Scheinkman, 2010. "Yesterday's Heroes: Compensation and Creative Risk-Taking," NBER Working Papers 16176, National Bureau of Economic Research, Inc.
  7. Diamond, Douglas W & Verrecchia, Robert E, 1982. " Optimal Managerial Contracts and Equilibrium Security Prices," Journal of Finance, American Finance Association, vol. 37(2), pages 275-87, May.
  8. Lazear, Edward P & Rosen, Sherwin, 1981. "Rank-Order Tournaments as Optimum Labor Contracts," Journal of Political Economy, University of Chicago Press, vol. 89(5), pages 841-64, October.
  9. Jin, Li & Myers, Stewart C., 2006. "R2 around the world: New theory and new tests," Journal of Financial Economics, Elsevier, vol. 79(2), pages 257-292, February.
  10. Philippe Aghion & Jeremy C. Stein, 2008. "Growth versus Margins: Destabilizing Consequences of Giving the Stock Market What It Wants," Journal of Finance, American Finance Association, vol. 63(3), pages 1025-1058, 06.
  11. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
  12. Acharya, Viral V & Yorulmazer, Tanju, 2004. "Too Many to Fail - An Analysis of Time Inconsistency in Bank Closure Policies," CEPR Discussion Papers 4778, C.E.P.R. Discussion Papers.
  13. Bruno Biais & Catherine Casamatta, 1999. "Optimal Leverage and Aggregate Investment," Journal of Finance, American Finance Association, vol. 54(4), pages 1291-1323, 08.
  14. Akerlof, George A, 1976. "The Economics of Caste and of the Rat Race and Other Woeful Tales," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 599-617, November.
  15. Ulf Axelson & Sandeep Baliga, 2009. "Liquidity and Manipulation of Executive Compensation Schemes," Review of Financial Studies, Society for Financial Studies, vol. 22(10), pages 3907-3939, October.
  16. Sudipto Bhattacharya & Dilip Mookherjee, 1986. "Portfolio Choice in Research and Development," RAND Journal of Economics, The RAND Corporation, vol. 17(4), pages 594-605, Winter.
  17. 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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