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How Important are Risk-Taking Incentives in Executive Compensation?Ingolf DittmannErasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Tinbergen Institute; Erasmus Research Institute of Management (ERIM); European Corporate Governance Institute (ECGI) Ko-Chia YuShanghai University of Finance and Economics - Finance; Tinbergen Institute; Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) November 25, 2011 Abstract: We consider a model in which shareholders provide a risk-averse CEO with risk-taking incentives in addition to effort incentives. We show that the optimal contract protects the CEO from losses for bad outcomes, is convex for medium outcomes, and concave for good outcomes. We calibrate the model to data on 727 CEOs and show that it can explain observed contracts much better than the standard model without risk-taking incentives. An application to contracts that consist of base salary, stock, and options yields that options should be issued in the money. Moreover, we propose a new measure of risk-taking (dis)incentives that measures the required profitability an additional risky project must exceed in order to be adopted by the CEO.
Number of Pages in PDF File: 51 Keywords: Stock Options, Effort Aversion, Loss Aversion, Risk-Taking Incentives, Optimal Strike Price JEL Classification: G30, M52 working papers seriesDate posted: July 26, 2008 ; Last revised: November 25, 2011Suggested CitationContact Information
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