Incentive Contracts, Market Risk, and Cost of Capital

28 Pages Posted: 3 Dec 2013

See all articles by Jeremy Bertomeu

Jeremy Bertomeu

University of California, San Diego (UCSD) - Rady School of Management

Date Written: December 2, 2013

Abstract

Should incentive contracts expose the agent to market-wide shocks? Counter-intuitively, I show that market risk cannot be filtered out from the compensation and managed independently by the agent. Under plausible risk preferences, the principal should offer a contract in which performance pay increases following a favorable market shock. In the aggregate, however, the effect of market risk on individual contracts diversifies away and the agency problem does not directly affect the cost of capital. The analysis suggests caution in interpreting changes in cost of capital in terms of the stewardship role of accounting information.

Keywords: agency, cost of capital, asset pricing, stewardship, principal-agent, theory

JEL Classification: D2, E3, G1, M1, M4.

Suggested Citation

Bertomeu, Jeremy, Incentive Contracts, Market Risk, and Cost of Capital (December 2, 2013). Contemporary Accounting Research, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2362474 or http://dx.doi.org/10.2139/ssrn.2362474

Jeremy Bertomeu (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

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