Risk Aversion, Prudence, and Compensation
November 9, 2012
In a standard principal-agent setting, we use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by managers with utility function u who are risk averse (u'' < 0) and prudent (u''' > 0). 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, and we decompose the effect of a change in the probability distribution of performances on the form of the optimal contract into three components.
Number of Pages in PDF File: 37
Keywords: downside risk, executive compensation, principal-agent model, prudence, risk preferences, stock-options
JEL Classification: D80, D86, J33working papers series
Date posted: January 19, 2012 ; Last revised: November 11, 2012
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