Dynamic Compensation under Uncertainty Shocks and Limited Commitment
AFA 2015 Boston Meetings Paper
43 Pages Posted: 22 Aug 2013
Date Written: June 30, 2018
This paper studies dynamic firm compensation and risk management under cash flow volatility shocks. Back-loaded compensation with a penalty upon the arrival of the volatility shock is used to incentivize effort and prudence from managers. As such, the optimal contract depends critically on firms' ability to commit to future compensation. Firms with full commitment power impose high pay-performance sensitivity and large penalties to implement low risk. Such firms defer compensation more when volatility becomes higher. In contrast, firms with limited commitment ability optimally allow excessive risk-taking from managers in exchange for low pay-performance sensitivity. These firms expedite compensation when volatility is higher, because their commitment to deliver on future payments becomes less credible. These predictions help make sense of empirical observations, in particular the controversial compensation practices during the recent financial crisis.
Keywords: dynamic agency, uncertainty shock, limited commitment
JEL Classification: D82, D86, G34, M12
Suggested Citation: Suggested Citation