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Risk Aversion, Prudence, and Compensation

Forthcoming, European Journal of Finance

23 Pages Posted: 19 Jan 2012 Last revised: 8 Aug 2014

Pierre Chaigneau

Queen's University

Date Written: July 2014

Abstract

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, managerial prudence can contribute to explain the prevalence of stock-options in executive compensation. However, convex contracts are not optimal when the principal is sufficiently prudent relative to the manager.

Keywords: downside risk, executive compensation, principal-agent model, prudence, risk preferences, stock options

JEL Classification: D80, D86, J33

Suggested Citation

Chaigneau, Pierre, Risk Aversion, Prudence, and Compensation (July 2014). Forthcoming, European Journal of Finance. Available at SSRN: https://ssrn.com/abstract=1988375 or http://dx.doi.org/10.2139/ssrn.1988375

Pierre Chaigneau (Contact Author)

Queen's University ( email )

Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

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