Entrepreneurial Incentives in Stock Market Economies

Alberto Bisin and Viral Acharya

No 3474, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: A Capital Asset Pricing Model of a stock market economy is examined under different corporate governance structures in which the objectives of managers and entrepreneurs in choosing the risk composition of their firms' returns are not aligned with those of shareholders and investors because of moral hazard. It is shown that incentive compensation, by exposing managers and entrepreneurs to unhedgeable firm-specific risk, induces them to change the stochastic properties of firm cash flows. Since they can trade in markets for aggregate risk but not for firm-specific risk, managers and entrepreneurs produce excessive aggregate risk compared to the first-best allocation. This results in a diversification externality for the stock market investors who cannot share the aggregate risks amongst each other as well as they can the firm-specific risks. The optimal incentive compensation designed to address such diversification externality is fully characterized and it is demonstrated that financial markets interact with the stock market in important ways in determining the effectiveness of incentive contracts in controlling the negative welfare effects of diversification externality.

Keywords: entrepreneurship; Managerial incentives; Hedging; Aggregate risk; Idiosyncratic risk; Stock market efficiency; Capm; Financial innovation (search for similar items in EconPapers)
JEL-codes: D52 D62 G10 G31 G32 J33 (search for similar items in EconPapers)
Date: 2002-07
New Economics Papers: this item is included in nep-cfn
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://cepr.org/publications/DP3474 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:3474

Ordering information: This working paper can be ordered from
https://cepr.org/publications/DP3474

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().