Consistency Between Principal and Agent With Differing Time Horizons: Computing Incentives Under Risk

Abstract

In a parsimonious model, we analyze how to obtain consistent incentives when both principal and agent are risk-averse and when a setting prevails in which the agent may have a shorter time horizon than the principal. Intertemporal dependencies in risky cash flows are taken into account.

Building on the fundamental results produced by Rogerson (Journal of Political Economy 105(4):770–795, 1997) and Reichelstein (Review of Accounting Studies 2(2):157–180, 1997), we establish a new risk allocation scheme, which enables consistent incentives to be achieved. Thereby, we demonstrate that the resulting performance measures correspond to an affine transformation of previous and current residual incomes or, alternatively, cash flows in such a way that information asymmetry between principal and agent is still possible. The risk allocation technique developed may prove useful in other contexts.

Keywords: Decision analysis, Investment decision, Intertemporal dependencies, Performance measure, Relative benefit cost allocation

JEL Classification: D82, G31, M41