The Valuation of Assets under Moral Hazard

Abstract

The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of managers 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. EXTANT ASSET VALUATION MODELS assume that the probability distribution of asset returns is exogenous to the valuation process itself and beyond the influence of those involved in the ownership and management of the asset. Since the plausibility of such an assumption is suspect for an actively managed asset, our main objective is to relax this assumption and characterize Pareto optimal managerial incentive contracts in a setting in which managers can affect asset returns through ex post unobservable actions. The economy has two types of economic agents-principals and agents. Principals, who may be risk averse, are endowed with capital, but they lack the skills to efficiently manage the assets they own. Thus, they must hire managers who have mean-variance utility functions and are in elastic supply.' Managers are assumed to possess no initial capital and, consequently, they must sell their services to satisfy their consumption needs. The incentive contracts by which managers are compensated are linear. For simplicity, all managers have identical preferences and skills. Allowing principals to be risk averse is important if the asset's profitability is not a diversifiable risk. The assumption of mean-variance utility is common in portfolio theory. The linearity constraint on incentive contracts is admittedly