Do Incentives Contracts Lead to Higher Risk-taking? The Impact of Executives' Characteristics

Abstract

Stock-option compensation is coherent with the principle of agency theory, by encouraging risk averse executives to take a more risk neutral stance. However, it is unclear whether the contract is actually more powerful than personal characteristics in shaping decision-making. We compare experimentally the risk aversion and prudence of 100 participants under a stock-option incentive contract and a classic equity granting one. We measure a number of personality variables, as well as cortisol and testosterone levels, which have been related to risk taking in previous studies. We first underline that stock-options contract indeed drives more risk neutral behaviour, both regarding variance and skewness. This effect is mainly driven by a shift in focus from losses to gains. Loss aversion and higher cortisol levels were linked to a preference for the safer equity contract. Second, we show that cortisol and testosterone levels are linked to preferences for variance and skewness, often in a quadratic fashion. Third, we show that this impact is actually stronger than the one of the contract, both in terms of predictive power and economic effect. Therefore, our study highlights the impact of personality and even biological variables on risk taking, and underline the need for a behavioural approach of contract setting.