Incentive Contracts and Downside Risk Sharing

30 Pages Posted: 3 Nov 2011 Last revised: 31 Aug 2017

See all articles by Bernard Sinclair-Desgagne

Bernard Sinclair-Desgagne

SKEMA Business School - Sophia Antipolis Campus

Sandrine Spaeter

French National Center for Scientific Research (CNRS) - Bureau of Economic Theory and Application (BETA)

Date Written: August 30, 2017

Abstract

This paper seeks to characterize incentive compensation in a static principal-agent moral hazard setting in which both the principal and the agent are prudent (or downside risk averse). We show that optimal incentive pay should then be `approximately concave' in performance, the approximation being closer the more downside risk averse the principal is compared to the agent. Limiting the agent's liability would improve the approximation, but taxing the principal would make it coarser. The notion of an approximately concave function we introduce here to describe optimal contracts is relatively recent in mathematics; it is intuitive and translates into concrete empirical implications, notably for the composition of incentive pay packages. We also clarify which measure of prudence - among the various ones proposed in the literature - is relevant to investigate the tradeoff between downside risk sharing and incentives.

Keywords: Pay-performance relationship; Compensation mix and incentives; Executive remuneration; Downside risk aversion; Prudence; Approximate concavity

JEL Classification: D82, M12, M52

Suggested Citation

Sinclair-Desgagne, Bernard and Spaeter, Sandrine, Incentive Contracts and Downside Risk Sharing (August 30, 2017). Available at SSRN: https://ssrn.com/abstract=1953548 or http://dx.doi.org/10.2139/ssrn.1953548

Bernard Sinclair-Desgagne (Contact Author)

SKEMA Business School - Sophia Antipolis Campus ( email )

60 rue Dostoïevski
Sophia Antipolis, 06902
France

Sandrine Spaeter

French National Center for Scientific Research (CNRS) - Bureau of Economic Theory and Application (BETA) ( email )

61, avenue de la Foret-Noire
F-67 085 Strasbourg Cedex
France
+33 03 9024 2076 (Phone)
+33 03 9024 2071 (Fax)

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