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The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts

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  • Pierre Chaigneau

Abstract

We use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by risk averse managers, in a fairly general setting. We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. This is because concave contracts concentrate incentives where the marginal utility of risk averse managers is highest, while convex contracts protect against downside risk. Thus, prudence can contribute to explain the prevalence of stock-options in executive compensation. We also present a condition on the utility function which enables to compare the structure of optimal contracts associated with different risk preferences.

Suggested Citation

  • Pierre Chaigneau, 2012. "The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts," Cahiers de recherche 1209, CIRPEE.
    • Handle: RePEc:lvl:lacicr:1209
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    References listed on IDEAS

    as
    1. Jenter, Dirk, 2004. "Executive Compensation, Incentives, and Risk," Working papers 4466-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
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    6. Chaigneau, Pierre, 2013. "Explaining the structure of CEO incentive pay with decreasing relative risk aversion," Journal of Economics and Business, Elsevier, vol. 67(C), pages 4-23.
    7. Ingolf Dittmann & Ko-Chia Yu & Dan Zhang, 2017. "How Important Are Risk-Taking Incentives in Executive Compensation?," Review of Finance, European Finance Association, vol. 21(5), pages 1805-1846.
    8. Ingolf Dittmann & Ernst Maug & Oliver Spalt, 2010. "Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse," Journal of Finance, American Finance Association, vol. 65(6), pages 2015-2050, December.
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    12. W Henry Chiu, 2010. "Skewness Preference, Risk Taking and Expected Utility Maximisation," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 35(2), pages 108-129, December.
    13. Keenan, Donald C. & Snow, Arthur, 2010. "Greater prudence and greater downside risk aversion," Journal of Economic Theory, Elsevier, vol. 145(5), pages 2018-2026, September.
    14. Lambert, Ra & Larcker, Df & Verrecchia, Re, 1991. "Portfolio Considerations In Valuing Executive-Compensation," Journal of Accounting Research, Wiley Blackwell, vol. 29(1), pages 129-149.
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    16. Stephen A. Ross, 2004. "Compensation, Incentives, and the Duality of Risk Aversion and Riskiness," Journal of Finance, American Finance Association, vol. 59(1), pages 207-225, February.
    17. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
    18. Kraus, Alan & Litzenberger, Robert H, 1976. "Skewness Preference and the Valuation of Risk Assets," Journal of Finance, American Finance Association, vol. 31(4), pages 1085-1100, September.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Executive compensation; principal-agent model; prudence; risk preferences; stock-options;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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