How Important are Risk-Taking Incentives in Executive Compensation?

How Important are Risk-Taking Incentives in Executive Compensation?

Ingolf Dittmann, Ko-Chia Yu, Dan Zhang

Series number :

Serial Number: 
473/2016

Date posted :

August 01 2016

Last revised :

August 09 2016
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Keywords

  • Stock Options • 
  • Effort Aversion • 
  • executive compensation • 
  • risk aversion • 
  • Risk-Taking Incentives • 
  • Optimal Strike Price

We consider a model in which shareholders provide a risk-averse CEO with risk-taking incentives in addition to effort incentives. We show that the optimal contract protects the CEO from losses for bad outcomes, is convex for medium outcomes, and concave for good outcomes.

We calibrate the model to data on 1,707 CEOs and show that it explains observed contracts much better than the standard model without risk-taking incentives. An application to contracts that consist of base salary, stock, and options yields that options should be issued in the money. Our model also helps us rationalize the universal use of at-the-money options when the tax code is taken into account. Moreover, we propose a new measure of risk-taking incentives that trades off the expected value added to the firm and the additional risk a CEO has to take.

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Published in

Published in: 
Publication Title: 
Review of Finance
Description: 
Volume 21, Issue 5, 1 August 2017, Pages 1805–1846

Authors

Real name: 
Ko-Chia Yu
Real name: 
Dan Zhang