Dynamic Compensation under Uncertainty Shocks and Limited Commitment

Abstract

This paper studies dynamic compensation and risk management under cash flow volatility shocks. The optimal contract depends critically on firms' ability to make good on promised future payments to managers. When volatility is low, firms with full commitment ability implement high pay-performance sensitivity to motivate effort from managers, and impose large penalties on the arrival of volatility shocks to incentivize prudent risk management. In contrast, firms with limited commitment may allow excessive risk-taking in exchange for low pay-performance sensitivity. When volatility becomes high, firms with full commitment defer compensation more while firms with limited commitment must expedite payments.

Keywords: dynamic agency, uncertainty shock, risk management, limited commitment

JEL Classification: D86, G32, M12