An Equilibrium Model of Asset Pricing and Moral Hazard

49 Pages Posted: 23 Oct 2002

See all articles by Hui Ou-Yang

Hui Ou-Yang

Cheung Kong Graduate School of Business

Multiple version iconThere are 3 versions of this paper

Date Written: December 15, 2002

Abstract

This paper develops an integrated model of asset pricing and moral hazard. In particular, we combine a version of the Capital Asset Pricing Model (CAPM) with a multi-agent moral hazard model. The excess returns for risky assets, optimal contracts for managers (agents) that involve relative performance, and equilibrium asset prices are explicitly characterized. We show that the CAPM linear relation still holds in the presence of moral hazard and that our beta is given by the ratio of the covariance between a firm's asset return and the market return over the variance of the market return, with both returns adjusted for the compensation to the managers. An empirical implication of the model is that there exists a negative relationship between an asset's return and its manager's pay-performance sensitivity. Furthermore, after controlling for certain factors, there exists a positive relationship between an asset's return and its idiosyncratic risk. We also show that the risk aversion of the principal in our model leads to less emphasis on relative performance evaluation than in a model with a risk-neutral principal. This result may shed light on why the empirical evidence for relative performance evaluation is mixed, even though the theoretical prediction based on a risk-neutral principal strongly supports it.

Suggested Citation

Ou-Yang, Hui, An Equilibrium Model of Asset Pricing and Moral Hazard (December 15, 2002). AFA 2003 Washington, DC Meetings. Available at SSRN: https://ssrn.com/abstract=341900 or http://dx.doi.org/10.2139/ssrn.341900

Hui Ou-Yang (Contact Author)

Cheung Kong Graduate School of Business ( email )

Hong Kong
China
852-5199-6227 (Phone)

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