How Important are Risk-Taking Incentives in Executive Compensation?

53 Pages Posted: 26 Jul 2008 Last revised: 27 Mar 2017

See all articles by Ingolf Dittmann

Ingolf Dittmann

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE); Tinbergen Institute; Erasmus Research Institute of Management (ERIM); European Corporate Governance Institute (ECGI)

Ko-Chia Yu

National Chung Cheng University

Dan Zhang

Oslo and Akershus University College - Oslo Metropolitan University; BI Norwegian Business School

Date Written: March 13, 2017

Abstract

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 and is convex for medium outcomes and concave for good outcomes. We calibrate the model to data on 1,707 CEOs and show that it explains observed contracts much better than the standard model without risk-taking incentives. When we apply the model to contracts that consist of base salary, stock, and options, the results suggest that options should be issued in the money. Our model also helps us rationalize the universal use of at-the-money options when the tax code is taken into account. Moreover, we propose a new way of measuring risk-taking incentives in which the expected value added to the firm is traded off against the additional risk a CEO has to bear.

Keywords: Stock Options, Effort Aversion, Executive Compensation, Risk Aversion, Risk-Taking Incentives, Optimal Strike Price

JEL Classification: G30, M52

Suggested Citation

Dittmann, Ingolf and Yu, Ko-Chia and Zhang, Dan, How Important are Risk-Taking Incentives in Executive Compensation? (March 13, 2017). Review of Finance, Forthcoming; European Corporate Governance Institute (ECGI) - Finance Working Paper No. 473/2016. Available at SSRN: https://ssrn.com/abstract=1176192 or http://dx.doi.org/10.2139/ssrn.1176192

Ingolf Dittmann (Contact Author)

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands
+31 10 4081283 (Phone)
+31 10 4089165 (Fax)

HOME PAGE: http://people.few.eur.nl/dittmann/

Tinbergen Institute

P.O. Box 1738
3000 DR Rotterdam
Netherlands

Erasmus Research Institute of Management (ERIM)

P.O. Box 1738
3000 DR Rotterdam
Netherlands

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Ko-Chia Yu

National Chung Cheng University ( email )

Min-Shiung, Chia-Yi, 621
Taiwan

Dan Zhang

Oslo and Akershus University College - Oslo Metropolitan University ( email )

PO Box 4, St Olavs plass
Oslo, 0130
Norway

BI Norwegian Business School ( email )

Nydalsveien 37
Oslo, 0442
Norway

HOME PAGE: http://www.bi.edu/research/employees/?ansattid=A1210112

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