IDEAS home Printed from https://ideas.repec.org/p/ehl/lserod/119059.html
   My bibliography  Save this paper

Explaining the structure of CEO incentive pay with decreasing relative risk aversion

Author

Listed:
  • Chaigneau, Pierre

Abstract

It is established that the standard principal-agent model cannot explain the structure of commonly used CEO compensation contracts if CRRA preferences are postulated. However, we demonstrate that this model has potentially a high explanatory power with preferences with decreasing relative risk aversion, in the sense that a typical CEO contract is approximately optimal for plausible preference parameters.

Suggested Citation

  • Chaigneau, Pierre, 2011. "Explaining the structure of CEO incentive pay with decreasing relative risk aversion," LSE Research Online Documents on Economics 119059, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:119059
    as

    Download full text from publisher

    File URL: http://eprints.lse.ac.uk/119059/
    File Function: Open access version.
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Vidhi Chhaochharia & Yaniv Grinstein, 2009. "CEO Compensation and Board Structure," Journal of Finance, American Finance Association, vol. 64(1), pages 231-261, February.
    2. Kimball, Miles S, 1990. "Precautionary Saving in the Small and in the Large," Econometrica, Econometric Society, vol. 58(1), pages 53-73, January.
    3. Hall, Brian J. & Murphy, Kevin J., 2002. "Stock options for undiversified executives," Journal of Accounting and Economics, Elsevier, vol. 33(1), pages 3-42, February.
    4. Xavier Gabaix & Augustin Landier, 2008. "Why has CEO Pay Increased So Much?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 123(1), pages 49-100.
    5. Smith, Clifford Jr. & Watts, Ross L., 1992. "The investment opportunity set and corporate financing, dividend, and compensation policies," Journal of Financial Economics, Elsevier, vol. 32(3), pages 263-292, December.
    6. Bryan, Stephen & Hwang, LeeSeok & Lilien, Steven, 2000. "CEO Stock-Based Compensation: An Empirical Analysis of Incentive-Intensity, Relative Mix, and Economic Determinants," The Journal of Business, University of Chicago Press, vol. 73(4), pages 661-693, October.
    7. Meyer, Donald J. & Meyer, Jack, 2005. "Risk preferences in multi-period consumption models, the equity premium puzzle, and habit formation utility," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1497-1515, November.
    8. Ait-Sahalia, Yacine & Lo, Andrew W., 2000. "Nonparametric risk management and implied risk aversion," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 9-51.
    9. Pierre-Olivier Gourinchas & Jonathan A. Parker, 2001. "The Empirical Importance of Precautionary Saving," American Economic Review, American Economic Association, vol. 91(2), pages 406-412, May.
    10. Brian J. Hall & Thomas A. Knox, 2004. "Underwater Options and the Dynamics of Executive Pay‐to‐Performance Sensitivities," Journal of Accounting Research, Wiley Blackwell, vol. 42(2), pages 365-412, May.
    11. Guiso, Luigi & Jappelli, Tullio & Terlizzese, Daniele, 1996. "Income Risk, Borrowing Constraints, and Portfolio Choice," American Economic Review, American Economic Association, vol. 86(1), pages 158-172, March.
    12. Ingolf Dittmann & Ernst Maug, 2007. "Lower Salaries and No Options? On the Optimal Structure of Executive Pay," Journal of Finance, American Finance Association, vol. 62(1), pages 303-343, February.
    13. Pierre-Olivier Gourinchas & Jonathan A. Parker, 2002. "Consumption Over the Life Cycle," Econometrica, Econometric Society, vol. 70(1), pages 47-89, January.
    14. Glenn W. Harrison & Morten I. Lau & E. Elisabet Rutström, 2007. "Estimating Risk Attitudes in Denmark: A Field Experiment," Scandinavian Journal of Economics, Wiley Blackwell, vol. 109(2), pages 341-368, June.
    15. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
    16. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-1370, November.
    17. Ogaki, Masao & Zhang, Qiang, 2001. "Decreasing Relative Risk Aversion and Tests of Risk Sharing," Econometrica, Econometric Society, vol. 69(2), pages 515-526, March.
    18. Mehran, Hamid, 1995. "Executive compensation structure, ownership, and firm performance," Journal of Financial Economics, Elsevier, vol. 38(2), pages 163-184, June.
    19. Larry G. Epstein & Stanley E. Zin, 2013. "Substitution, risk aversion and the temporal behavior of consumption and asset returns: A theoretical framework," World Scientific Book Chapters, in: Leonard C MacLean & William T Ziemba (ed.), HANDBOOK OF THE FUNDAMENTALS OF FINANCIAL DECISION MAKING Part I, chapter 12, pages 207-239, World Scientific Publishing Co. Pte. Ltd..
    20. O. Ashenfelter & D. Card (ed.), 1999. "Handbook of Labor Economics," Handbook of Labor Economics, Elsevier, edition 1, volume 3, number 3.
    21. Matthew Rabin, 2000. "Risk Aversion and Expected-Utility Theory: A Calibration Theorem," Econometrica, Econometric Society, vol. 68(5), pages 1281-1292, September.
    22. Fudenberg, Drew & Tirole, Jean, 1984. "The Fat-Cat Effect, the Puppy-Dog Ploy, and the Lean and Hungry Look," American Economic Review, American Economic Association, vol. 74(2), pages 361-366, May.
    23. Ingolf Dittmann & Ko-Chia Yu & Dan Zhang, 2017. "How Important Are Risk-Taking Incentives in Executive Compensation?," Review of Finance, European Finance Association, vol. 21(5), pages 1805-1846.
    24. Szpiro, George G, 1986. "Measuring Risk Aversion: An Alternative Approach," The Review of Economics and Statistics, MIT Press, vol. 68(1), pages 156-159, February.
    25. Ingolf Dittmann & Ernst Maug & Oliver Spalt, 2010. "Sticks or Carrots? Optimal CEO Compensation when Managers Are Loss Averse," Journal of Finance, American Finance Association, vol. 65(6), pages 2015-2050, December.
    26. Siegel, Frederick W & Hoban, James P, Jr, 1982. "Relative Risk Aversion Revisited," The Review of Economics and Statistics, MIT Press, vol. 64(3), pages 481-487, August.
    27. Martin Browning & Annamaria Lusardi, 1996. "Household Saving: Micro Theories and Micro Facts," Journal of Economic Literature, American Economic Association, vol. 34(4), pages 1797-1855, December.
    28. Cohn, Richard A, et al, 1975. "Individual Investor Risk Aversion and Investment Portfolio Composition," Journal of Finance, American Finance Association, vol. 30(2), pages 605-620, May.
    29. Graves, Philip E., 1979. "Relative Risk Aversion: Increasing or Decreasing?," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 14(2), pages 205-214, June.
    30. Kevin J. Murphy & Brian J. Hall, 2000. "Optimal Exercise Prices for Executive Stock Options," American Economic Review, American Economic Association, vol. 90(2), pages 209-214, May.
    31. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-543, June.
    32. Carola Frydman & Dirk Jenter, 2010. "CEO Compensation," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 75-102, December.
    33. repec:bla:revinw:v:37:y:1991:i:3:p:249-66 is not listed on IDEAS
    34. David de Meza & David C. Webb, 2007. "Incentive Design under Loss Aversion," Journal of the European Economic Association, MIT Press, vol. 5(1), pages 66-92, March.
    35. Jensen, Michael C & Murphy, Kevin J, 1990. "Performance Pay and Top-Management Incentives," Journal of Political Economy, University of Chicago Press, vol. 98(2), pages 225-264, April.
    36. Levy, Haim, 1994. "Absolute and Relative Risk Aversion: An Experimental Study," Journal of Risk and Uncertainty, Springer, vol. 8(3), pages 289-307, May.
    37. Lambert, Ra & Larcker, Df & Verrecchia, Re, 1991. "Portfolio Considerations In Valuing Executive-Compensation," Journal of Accounting Research, Wiley Blackwell, vol. 29(1), pages 129-149.
    38. Schooley, Diane K. & Worden, Debra Drecnik, 1996. "Risk aversion measures: comparing attitudes and asset allocation," Financial Services Review, Elsevier, vol. 5(2), pages 87-99.
    39. Yermack, David, 1995. "Do corporations award CEO stock options effectively?," Journal of Financial Economics, Elsevier, vol. 39(2-3), pages 237-269.
    40. Bellante, Don & Green, Carole A., 2004. "Relative risk aversion among the elderly," Review of Financial Economics, Elsevier, vol. 13(3), pages 269-281.
    41. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 113(3), pages 653-691.
    42. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-286, April.
    43. Blake, David, 1996. "Efficiency, Risk Aversion and Portfolio Insurance: An Analysis of Financial Asset Portfolios Held by Investors in the United Kingdom," Economic Journal, Royal Economic Society, vol. 106(438), pages 1175-1192, September.
    44. Grossman, Sanford J & Hart, Oliver D, 1983. "An Analysis of the Principal-Agent Problem," Econometrica, Econometric Society, vol. 51(1), pages 7-45, January.
    45. Robert B. Barsky & F. Thomas Juster & Miles S. Kimball & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 112(2), pages 537-579.
    46. Donald Meyer & Jack Meyer, 2005. "Relative Risk Aversion: What Do We Know?," Journal of Risk and Uncertainty, Springer, vol. 31(3), pages 243-262, December.
    47. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563, Elsevier.
    48. Alex Edmans & Xavier Gabaix, 2009. "Is CEO Pay Really Inefficient? A Survey of New Optimal Contracting Theories," European Financial Management, European Financial Management Association, vol. 15(3), pages 486-496, June.
    49. Denis Kessler & Edward N. Wolff, 1991. "A Comparative Analysis Of Household Wealth Patterns In France And The United States," Review of Income and Wealth, International Association for Research in Income and Wealth, vol. 37(3), pages 249-266, September.
    50. Ryan, Harley Jr. & Wiggins, Roy III, 2001. "The influence of firm- and manager-specific characteristics on the structure of executive compensation," Journal of Corporate Finance, Elsevier, vol. 7(2), pages 101-123, June.
    51. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
    52. Morin, Roger A & Fernandez Suarez, Antonio, 1983. "Risk Aversion Revisited," Journal of Finance, American Finance Association, vol. 38(4), pages 1201-1216, September.
    53. Karen E. Dynan, 1993. "How prudent are consumers?," Working Paper Series / Economic Activity Section 135, Board of Governors of the Federal Reserve System (U.S.).
    54. Alex Edmans & Xavier Gabaix & Augustin Landier, 2009. "A Multiplicative Model of Optimal CEO Incentives in Market Equilibrium," The Review of Financial Studies, Society for Financial Studies, vol. 22(12), pages 4881-4917, December.
    55. Kraus, Alan & Litzenberger, Robert H, 1976. "Skewness Preference and the Valuation of Risk Assets," Journal of Finance, American Finance Association, vol. 31(4), pages 1085-1100, September.
    56. Dynan, Karen E, 1993. "How Prudent Are Consumers?," Journal of Political Economy, University of Chicago Press, vol. 101(6), pages 1104-1113, December.
    57. Michael S. Weisbach, 2007. "Optimal Executive Compensation versus Managerial Power: A Review of Lucian Bebchuk and Jesse Fried's Pay without Performance: The Unfulfilled Promise of Executive Compensation," Journal of Economic Literature, American Economic Association, vol. 45(2), pages 419-428, June.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Pierre Chaigneau, 2012. "The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts," Cahiers de recherche 1209, CIRPEE.
    2. Ingolf Dittmann & Ko-Chia Yu & Dan Zhang, 2017. "How Important Are Risk-Taking Incentives in Executive Compensation?," Review of Finance, European Finance Association, vol. 21(5), pages 1805-1846.
    3. Tobias Huber & Johannes G. Jaspersen & Andreas Richter & Dennis Strümpel, 2023. "On the change of risk aversion in wealth: a field experiment in a closed economic system," Experimental Economics, Springer;Economic Science Association, vol. 26(1), pages 1-26, March.
    4. Pierre Chaigneau, 2012. "The effect of risk preferences on the valuation and incentives of compensation contracts," FMG Discussion Papers dp697, Financial Markets Group.
    5. repec:oup:rfinst:v:21:y:2017:i:5:p:1805-1846. is not listed on IDEAS
    6. Dilip B. Madan & King Wang, 2024. "On the real rate of interest in a closed economy," Annals of Finance, Springer, vol. 20(4), pages 459-477, December.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. J. Francois Outreville, 2014. "Risk Aversion, Risk Behavior, and Demand for Insurance: A Survey," Journal of Insurance Issues, Western Risk and Insurance Association, vol. 37(2), pages 158-186.
    2. Alex Edmans & Xavier Gabaix, 2016. "Executive Compensation: A Modern Primer," Journal of Economic Literature, American Economic Association, vol. 54(4), pages 1232-1287, December.
    3. J. François Outreville, 2015. "The Relationship Between Relative Risk Aversion And The Level Of Education: A Survey And Implications For The Demand For Life Insurance," Journal of Economic Surveys, Wiley Blackwell, vol. 29(1), pages 97-111, February.
    4. Carola Frydman & Dirk Jenter, 2010. "CEO Compensation," Annual Review of Financial Economics, Annual Reviews, vol. 2(1), pages 75-102, December.
    5. Alex Edmans & Xavier Gabaix & Augustin Landier, 2007. "A Calibratable Model of Optimal CEO Incentives in Market Equilibrium," NBER Working Papers 13372, National Bureau of Economic Research, Inc.
    6. Hongfei Tang, 2014. "Are CEO stock option grants optimal? Evidence from family firms and non-family firms around the Sarbanes–Oxley Act," Review of Quantitative Finance and Accounting, Springer, vol. 42(2), pages 251-292, February.
    7. Pierre Chaigneau, 2012. "The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts," Cahiers de recherche 1209, CIRPEE.
    8. Dong, Gang Nathan, 2014. "Excessive financial services CEO pay and financial crisis: Evidence from calibration estimation," Journal of Empirical Finance, Elsevier, vol. 27(C), pages 75-96.
    9. Gabaix, Xavier & Sannikov, Yuliy & Edmans, Alex & Sadzik, Tomasz, 2009. "Dynamic Incentive Accounts," CEPR Discussion Papers 7497, C.E.P.R. Discussion Papers.
    10. Guiso, Luigi & Sodini, Paolo, 2013. "Household Finance: An Emerging Field," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1397-1532, Elsevier.
    11. Hall, Brian J. & Murphy, Kevin J., 2002. "Stock options for undiversified executives," Journal of Accounting and Economics, Elsevier, vol. 33(1), pages 3-42, February.
    12. George Samartzis & Nikitas Pittis, 2022. "Dynamic Estimates Of The Arrow-Pratt Absolute And Relative Risk Aversion Coefficients," Papers 2211.03604, arXiv.org.
    13. Nie, George Y., 2024. "The Missing Dimension of Risk: Evidence from Inside Debt Maturity and Acquisition Choices," SocArXiv jd3c2, Center for Open Science.
    14. Liljeblom, Eva & Pasternack, Daniel & Rosenberg, Matts, 2011. "What determines stock option contract design?," Journal of Financial Economics, Elsevier, vol. 102(2), pages 293-316.
    15. Loureiro, Gilberto & Makhija, Anil K. & Zhang, Dan, 2011. "Why Do Some CEOs Work for a One-Dollary Salary?," Working Paper Series 2011-7, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
    16. Chaigneau, Pierre, 2012. "The effect of risk preferences on the valuation and incentives of compensation contracts," LSE Research Online Documents on Economics 119055, London School of Economics and Political Science, LSE Library.
    17. Julian Thimme, 2017. "Intertemporal Substitution In Consumption: A Literature Review," Journal of Economic Surveys, Wiley Blackwell, vol. 31(1), pages 226-257, February.
    18. Jenter, Dirk, 2004. "Executive Compensation, Incentives, and Risk," Working papers 4466-02, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    19. Yaowen Shan & Terry Walter, 2016. "Towards a Set of Design Principles for Executive Compensation Contracts," Abacus, Accounting Foundation, University of Sydney, vol. 52(4), pages 619-684, December.
    20. repec:oup:rfinst:v:21:y:2017:i:5:p:1805-1846. is not listed on IDEAS
    21. Nohel, Tom & Todd, Steven, 2005. "Compensation for managers with career concerns: the role of stock options in optimal contracts," Journal of Corporate Finance, Elsevier, vol. 11(1-2), pages 229-251, March.

    More about this item

    Keywords

    CEO pay; principal-agent model; corporate governance; stock-options;
    All these keywords.

    JEL classification:

    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ehl:lserod:119059. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: LSERO Manager (email available below). General contact details of provider: https://edirc.repec.org/data/lsepsuk.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.