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How Important Are Risk-Taking Incentives in Executive Compensation?

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  • Ingolf Dittmann

    (Erasmus University Rotterdam)

  • Ko-Chia Yu

    (Erasmus University Rotterdam)

Abstract

This paper investigates whether observed executive compensation contracts are designed to provide risk-taking incentives in addition to effort incentives. We develop a stylized principal-agent model that captures the interdependence between firm risk and managerial incentives. We calibrate the model to individual CEO data and show that it can explain observed compensation practice surprisingly well. In particular, it justifies large option holdings and high base salaries. Our analysis suggests that options should be issued in the money. If tax effects are taken into account, the model is consistent with the almost uniform use of at-the-money stock options. We conclude that the provision of risk-taking incentives is a major objective in executive compensation practice.

Suggested Citation

  • Ingolf Dittmann & Ko-Chia Yu, 2009. "How Important Are Risk-Taking Incentives in Executive Compensation?," Tinbergen Institute Discussion Papers 09-076/2, Tinbergen Institute.
  • Handle: RePEc:tin:wpaper:20090076
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    Cited by:

    1. 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.
    2. Edmans, Alex & Gabaix, Xavier, 2010. "Risk and CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOs?," Working Papers 10-17, University of Pennsylvania, Wharton School, Weiss Center.
    3. repec:eee:ecmode:v:71:y:2018:i:c:p:16-24 is not listed on IDEAS
    4. Alex Edmans & Xavier Gabaix, 2016. "Executive Compensation: A Modern Primer," Journal of Economic Literature, American Economic Association, vol. 54(4), pages 1232-1287, December.
    5. Edmans, Alex & Gabaix, Xavier & Sadzik, Tomasz & Sannikov, Yuliy, 2009. "Dynamic Incentive Accounts," CEPR Discussion Papers 7497, C.E.P.R. Discussion Papers.
    6. Chaigneau, Pierre, 2018. "The optimal timing of CEO compensation," Finance Research Letters, Elsevier, vol. 24(C), pages 90-94.
    7. Edmans, Alex & Gabaix, Xavier, 2010. "Risk and the CEO Market: Why Do Some Large Firms Hire Highly-Paid, Low-Talent CEOs?," CEPR Discussion Papers 7836, C.E.P.R. Discussion Papers.

    More about this item

    Keywords

    Stock Options; Executive Compensation; Effort Aversion; Risk-Taking Incentives; Optimal Strike Price;

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

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