The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts

Pierre Chaigneau

Cahiers de recherche from CIRPEE

Abstract: We use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by risk averse managers, in a fairly general setting. We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. This is because concave contracts concentrate incentives where the marginal utility of risk averse managers is highest, while convex contracts protect against downside risk. Thus, prudence can contribute to explain the prevalence of stock-options in executive compensation. We also present a condition on the utility function which enables to compare the structure of optimal contracts associated with different risk preferences.

Keywords: Executive compensation; principal-agent model; prudence; risk preferences; stock-options (search for similar items in EconPapers)
JEL-codes: D86 J33 (search for similar items in EconPapers)
Date: 2012
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Persistent link: https://EconPapers.repec.org/RePEc:lvl:lacicr:1209

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