Overconfidence,Compensation Contracts,and Capital Budgeting

A risk‐averse manager's overconfidence makes him less conservative. As a result, it is cheaper for firms to motivate him to pursue valuable risky projects. When compensation endogenously adjusts to reflect outside opportunities, moderate levels of overconfidence lead firms to offer the manager flatter compensation contracts that make him better off. Overconfident managers are also more attractive to firms than their rational counterparts because overconfidence commits them to exert effort to learn about projects. Still, too much overconfidence is detrimental to the manager since it leads him to accept highly convex compensation contracts that expose him to excessive risk.     

Managerial hedging,equity ownership,and firm value

Suppose risk‐averse managers can hedge the aggregate component of their exposure to firm's cash‐flow risk by trading in financial markets but cannot hedge their firm‐specific exposure. This gives them incentives to pass up firm‐specific projects in favor of standard projects that contain greater aggregate risk. Such forms of moral hazard give rise to excessive aggregate risk in stock markets. In this context, optimal managerial contracts induce a relationship between managerial ownership and (i) aggregate risk in the firm's cash flows, as well as (ii) firm value. We show that this can help explain the shape of the empirically documented relationship between ownership and firm performance.     

Employment risk,compensation incentives,and managerial risk taking: Evidence from the mutual fund industry

We examine the influence on managerial risk taking of incentives due to employment risk and due to compensation. Our empirical investigation of the risk taking behavior of mutual fund managers indicates that managerial risk taking crucially depends on the relative importance of these incentives. When employment risk is more important than compensation incentives, fund managers with a poor midyear performance tend to decrease risk relative to leading managers to prevent potential job loss. When employment risk is low, compensation incentives become more relevant and fund managers with a poor midyear performance increase risk to catch up with the midyear winners.     

High‐Water Marks: High Risk Appetites? Convex Compensation,Long Horizons,and Portfolio Choice

We study the portfolio choice of hedge fund managers who are compensated by high-water mark contracts. We find that even risk-neutral managers do not place unbounded weights on risky assets, despite option-like contracts. Instead, they place a constant fraction of funds in a mean-variance efficient portfolio and the rest in the riskless asset, acting as would constant relative risk aversion (CRRA) investors. This result is a direct consequence of the in(de)finite horizon of the contract. We show that the risk-seeking incentives of option-like contracts rely on combining finite horizons and convex compensation schemes rather than on convexity alone.     

Risk Aversion,Downside Risk Aversion and Paying for Stochastic Improvements

This paper considers the relationship between risk preferences and the willingness to pay for stochastic improvements. We show that if the stochastic improvement satisfies a double-crossing condition, then a decision maker with utility v is willing to pay more than a decision maker with utility u, if v is both more risk averse and less downside risk averse than u. As the condition always holds in the case of self-protection, the result implies novel characterizations of individuals’ willingness to pay to reduce the probability of loss. By establishing a general result on the correspondence between an individual's willingness to pay, and his optimal purchase of stochastic improvement when there is a given relationship between stochastic improvements and the amount paid for them, we further show that all results on the willingness to pay can be applied directly to characterize the conditions under which a more risk averse individual will optimally choose to buy more stochastic improvement. Generalizations of existing results on optimal choice of self-protection can be obtained as corollaries.     

Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse

This paper analyzes optimal executive compensation contracts when managers are loss averse. We calibrate a stylized principal‐agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parameterizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and that drops discontinuously to the lowest possible payout for low outcomes. Finally, we identify the critical features of the loss‐aversion model that render optimal contracts convex.     

Heterogeneity in the Effect of Managerial Equity Incentives on Firm Value

We document significant heterogeneity in the relation between chief executive officer (CEO) equity incentives and firm value using quantile regression. We show that CEO delta is more effective in the presence of ample investment opportunities, while CEO vega is more beneficial for firms lacking investment opportunities. Further, Tobin's Q increases in CEO delta for more risk‐tolerant firms but increases in CEO vega for more risk‐averse firms. We also observe that higher monitoring intensity after the Sarbanes‐Oxley Act reduces CEO delta's role in compensation. Risk aversion alters the optimal incentive‐value relation, and the nature of this relation also depends on the level of Tobin's Q.     

CEO Horizon,Optimal Pay Duration,and the Escalation of Short‐Termism

This paper studies optimal contracts when managers manipulate their performance measure at the expense of firm value. Optimal contracts defer compensation. The manager's incentives vest over time at an increasing rate, and compensation becomes very sensitive to short‐term performance. This generates an endogenous horizon problem whereby managers intensify performance manipulation in their final years in office. Contracts are designed to encourage effort while minimizing the adverse effects of manipulation. We characterize the optimal mix of short‐ and long‐term compensation along the manager's tenure, the optimal vesting period of incentive pay, and the dynamics of short‐termism over the CEO's tenure.     

The impact of the market portfolio on the valuation,incentives and optimality of executive stock options

This paper examines the effect on valuation and incentives of allowing executives receiving options to trade on the market portfolio. We propose a continuous time utility maximization model to value stock and option compensation from the executive's perspective. The executive may invest non-option wealth in the market and riskless asset but not in the company stock itself, leaving them subject to firm-specific risk for incentive?purposes. Since the executive is risk averse, this unhedgeable firm risk leads them to place less value on the options than their cost to the company.

By distinguishing between these two types of risks, we are able to examine the effect of stock volatility, firm-specific risk and market risk on the value to the executive. In particular, options do not give incentive to increase total risk, but rather to increase the proportion of market relative to firm-specific risk, so executives prefer high beta companies. The paper also examines the relationship between risk and incentives, and finds firm-specific risk decreases incentives whilst market risk may decrease incentives depending on other parameters. The model supports the use of stock rather than options if the company can adjust cash pay when granting stock-based compensation.     

Optimal Incentive Contracts for Loss‐Averse Managers: Stock Options versus Restricted Stock Grants

This paper provides an explanation for the widespread use of stock option grants in executive compensation. It shows that the optimal incentive contract for loss‐averse managers must contain a substantial portion of stock options even when it should consist exclusively of stock grants for “classical” risk‐averse managers. The paper also provides an explanation for the drastic increase in the risk‐adjusted level of CEO compensations over the past two decades and argues that more option‐based compensation should be used in firms with higher cash flow volatility and in industries with a higher degree of heterogeneity among firms.     

The relation between equity incentives and misreporting: The role of risk-taking incentives

Prior research argues that a manager whose wealth is more sensitive to changes in the firm?s stock price has a greater incentive to misreport. However, if the manager is risk-averse and misreporting increases both equity values and equity risk, the sensitivity of the manager?s wealth to changes in stock price (portfolio delta) will have two countervailing incentive effects: a positive “reward effect” and a negative “risk effect.” In contrast, the sensitivity of the manager?s wealth to changes in risk (portfolio vega) will have an unambiguously positive incentive effect. We show that jointly considering the incentive effects of both portfolio delta and portfolio vega substantially alters inferences reported in prior literature. Using both regression and matching designs, and measuring misreporting using discretionary accruals, restatements, and enforcement actions, we find strong evidence of a positive relation between vega and misreporting and that the incentives provided by vega subsume those of delta. Collectively, our results suggest that equity portfolios provide managers with incentives to misreport when they make managers less averse to equity risk.     

Termination Risk, Multiple Managers and Mutual Fund Tournaments

This study analyzes the risk-taking behavior of mutual funds in response to their relative performance over the 1992 to 1999 period. Our results show that managers of funds whose performance is closer to that of the top performing funds have greater incentives to increase their portfolios' risk than managers at the top who exhibit a tendency to lock in their positions. The evidence suggests that termination risk imposes a constraint on the risk taking behavior of under-performing fund managers and the winner takes all phenomenon generates a strong incentive for the fund managers to be the top manager. We also analyze the difference in the risk taking behavior of funds managed by multiple managers and single managers.     

Do Portfolio Manager Contracts Contract Portfolio Management?

Most mutual fund managers have performance‐based contracts. Our theory predicts that mutual fund managers with asymmetric contracts and mid‐year performance close to their announced benchmark increase their portfolio risk in the second part of the year. As predicted by our theory, performance deviation from the benchmark decreases risk‐shifting only for managers with performance contracts. Deviation from the benchmark dominates incentives from the flow‐performance relation, suggesting that risk‐shifting is motivated more by management contracts than by a tournament to capture flows.     

Optimal capital and risk allocations for law- and cash-invariant convex functions

In this paper we provide a complete solution to the existence and characterization problem of optimal capital and risk allocations for not necessarily monotone, law-invariant convex risk measures on the model space L ^p for any p∈[1,∞]. Our main result says that the capital and risk allocation problem always admits a solution via contracts whose payoffs are defined as increasing Lipschitz-continuous functions of the aggregate risk. Filipović is supported by WWTF (Vienna Science and Technology Fund). Svindland gratefully acknowledges financial support from Munich Re Grant for doctoral students and hospitality of the Research Unit of Financial and Actuarial Mathematics, Vienna University of Technology. We thank Beatrice Acciaio and Walter Schachermayer for fruitful discussions and an anonymous referee for helpful remarks.     

Investment,Idiosyncratic Risk,and Ownership

High‐powered incentives may induce higher managerial effort, but they also expose managers to idiosyncratic risk. If managers are risk averse, they might underinvest when firm‐specific uncertainty increases, leading to suboptimal investment decisions from the perspective of well‐diversified shareholders. We empirically document that, when idiosyncratic risk rises, firm investment falls, and more so when managers own a larger fraction of the firm. This negative effect of managerial risk aversion on investment is mitigated if executives are compensated with options rather than with shares or if institutional investors form a large part of the shareholder base.     

Strong Increases in Downside Risk Aversion

A ranking of risk preferences is of economic interest insofar as it leads to unambiguous comparative statics predictions, and for this to be the case, the ranking must be a strict partial ordering. The ranking by greater risk aversion meets this demand at the second order, and yields a variety of well-known predictions concerning the effect of greater risk aversion on demands for insurance and risky assets, among many other applications. There has been less success at the third order, where ranking preferences by aversion to downside risk has not produced a strict partial ordering. The problem is that account has not been taken of the fact that an increase in downside risk aversion must induce changes in risk aversion as well. We propose a definition of stronger downside risk aversion that does yield a strict partial ordering by requiring a nested increase in both second- and third-order risk aversion, so that v is more strongly downside risk averse than u if v is more risk averse and more downside risk averse than u. We demonstrate that v being more strongly downside risk averse than u is characterized by v never liking any change in the probability distribution for y that induces a third-order stochastic dominance deterioration in the distribution for u(y). We apply the definition to obtain intuitive comparative statics predictions in the precautionary saving problem, and relate the definition to alternatives proposed in the literature.     

Lower Salaries and No Options? On the Optimal Structure of Executive Pay

We calibrate the standard principal–agent model with constant relative risk aversion and lognormal stock prices to a sample of 598 U.S. CEOs. We show that this model predicts that most CEOs should not hold any stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies; many would be required to purchase additional stock in their companies. These contracts would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We conclude that the standard principal–agent model typically used in the literature cannot rationalize observed contracts.     

Rethinking “Strength of Incentives” for Executives of Financial Institutions

The recent crisis has caused some finance theorists and practitioners to rethink the effects of managerial incentives on the total enterprise value of large financial institutions. This re-examination has identified and analyzed a number of potential problems with the use of equity-based compensation, including insufficiently long managerial time horizons as well as the temptation for excessive risk-taking provided by “asymmetric” payoff structures in which shareholders have virtually all the upside while debtholders bear most of the downside risk. In an attempt to address such problems, finance and governance scholars have increasingly explored the possible value of aligning managerial interests with those of not only shareholders, but other important corporate claimants such as debtholders and taxpayers. After reviewing the latest thinking about risk and managerial incentives at financial institutions, the authors come to the following conclusions:

• • The design of incentives for value maximization needs to reflect a healthy appreciation of downside risk as well as upside reward, and both senior and subordinated debt may be ideal instruments for establishing that balance. At the same time, most senior executives should continue to receive equity-linked compensation in addition to significant proportions of “inside debt.”
• • Since decision-makers below the highest level executives of large financial institutions collectively wield enormous power to assume and manage risks, this “upper-middle” tier of managers deserves special attention. Rather than rewarding these managers with stock or options, the authors suggest use of a combination of uncapped but “held-at-risk” bonuses denominated in subordinated inside debt as the best way of rewarding effort and competence while controlling opportunities for risk-shifting.

     

Timeliness of Spread Implied Ratings

Rating agencies are known to be prudent in their approach to rating revisions, which results in delayed rating adjustments. For a large set of eurobonds we derive credit spread implied ratings and compare them with agency ratings. Our results indicate that spread implied ratings often anticipate the future movement of agency ratings and hence can help track credit risk in a more timely manner. This finding has important implications for risk managers in banks who, under the new Basel 2 regulations, have to rely more on credit ratings for capital allocation purposes, and for portfolio managers who face rating‐related investment restrictions.     

Efficient Insurance Contracts under Epsilon-Contaminated Utilities

This paper analyses the qualitative properties of optimal contracts when agents have multiple priors and are uncertainty averse in an infinite state space framework. The case of the epsilon-contamination of a given prior, a basic tool in robustness theory is fully developped. It is shown that if both agents have strictly concave utility index, then if the insurer is less uncertainty averse than the insured, he provides a full insurance contract above a deductible for high values of the loss.