Uncertainty, Risk, and Incentives: Theory and Evidence
University of Chicago - Booth School of Business, and NBER
Wilfrid Laurier University - School of Business & Economics
Board of Governors of the Federal Reserve System (FRB)
University of Minnesota
October 21, 2012
Sixth Singapore International Conference on Finance 2012 Paper
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 the 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 tradeoff, this 'learning-by-doing' effect generates a positive relation between profitability uncertainty and incentives. We document empirical support for this prediction.
Number of Pages in PDF File: 38
Keywords: executive compensation, optimal contracting, learning, uncertainty, risk-incentive trade-off
Date posted: November 7, 2010 ; Last revised: February 24, 2013
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