Dynamic risk taking with bonus schemes

Dietmar P.J. Leisen

Quantitative Finance, 2015, vol. 15, issue 9, 1583-1596

Abstract: This paper studies dynamic risk taking by a risk-averse manager who receives a bonus; the company may default on its contractual obligations (debt and fixed compensation). We show that risk taking is time independent, and is summarized by the so-called risk aversion of derived utility. We highlight the importance of dynamic aspects and provide a foundation for common qualitative discussions that are based on characteristics of bonus functions. The paper cautions that deferral of fixed compensation may increase risk taking. Finally, we motivate a new bonus scheme that incentivizes the manager to implement the socially optimal risk level.

Date: 2015
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DOI: 10.1080/14697688.2014.969299

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