The Valuation of Assets under Moral Hazard

Ram T. S. Ramakrishnan and Anjan Thakor ()
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Ram T. S. Ramakrishnan: Sloan School of Management, M.I.T.

Finance from University Library of Munich, Germany

Abstract: The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of manages can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms.

JEL-codes: G (search for similar items in EconPapers)
Date: 2004-11-11
New Economics Papers: this item is included in nep-fin
Note: Type of Document - pdf
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Journal Article: The Valuation of Assets under Moral Hazard (1984)
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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0411032

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