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Stock market tournaments

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  • Ozdenoren, Emre
  • Yuan, Kathy

Abstract

We propose a new theory of suboptimal risk-taking based on contractual externalities. We examine an industry with a continuum of firms. Each firm's manager exerts costly hidden effort. The productivity of effort is subject to systematic shocks. Firms' stock prices reflect their performance relative to the industry average. In this setting, stock-based incentives cause complementarities in managerial effort choices. Externalities arise because shareholders do not internalize the impact of their incentive provision on the average effort. During booms, they over-incentivise managers, triggering a rat-race in effort exertion, resulting in excessive risk relative to the second-best. The opposite occurs during busts.

Suggested Citation

  • Ozdenoren, Emre & Yuan, Kathy, 2012. "Stock market tournaments," LSE Research Online Documents on Economics 119047, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:119047
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    More about this item

    Keywords

    stock-based incentives; excessive risk-taking; insufficient risk-taking; contractual externalites;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G00 - Financial Economics - - General - - - General
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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