Investments and Risk Transfers

51 Pages Posted: 23 Jan 2017 Last revised: 6 Feb 2018

See all articles by Tim Baldenius

Tim Baldenius

Columbia Buiness School

Beatrice Michaeli

University of California, Los Angeles (UCLA)

Date Written: March 4, 2011

Abstract

We demonstrate a novel link between relationship-specific investments and risk in a setting where division managers operate under moral hazard and collaborate on joint projects. Specific investments increase efficiency at the margin. This expands the scale of operations and thereby adds to the compensation risk borne by the managers. Accounting for this investment/risk link overturns key findings from prior incomplete contracting studies. We find that, if the investing manager has full bargaining power vis-a-vis the other manager, he will underinvest relative to the benchmark of contractible investments; with equal bargaining power, however, he may overinvest. The reason is that the investing manager internalizes only his own share of the investment-induced risk premium (we label this a "risk transfer"), whereas the principal internalizes both managers' incremental risk premia. We show that high pay-performance sensitivity (PPS) reduces the managers' incentives to invest in relationship-specific assets. The optimal PPS thus trades off investment and effort incentives.

Keywords: incomplete contracting, hold-up, risk externalities, overinvestment, pay performance sensitivity (PPS)

JEL Classification: D86, M52, D02

Suggested Citation

Baldenius, Tim and Michaeli, Beatrice, Investments and Risk Transfers (March 4, 2011). The Accounting Review, 2017, Volume 92(6), Available at SSRN: https://ssrn.com/abstract=2902994 or http://dx.doi.org/10.2139/ssrn.2902994

Tim Baldenius (Contact Author)

Columbia Buiness School ( email )

3022 Broadway
New York, NY 10027
United States

Beatrice Michaeli

University of California, Los Angeles (UCLA) ( email )

D410 Anderson Complex
Los Angeles, CA 90095
United States

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