Risk-averse Managers Research Articles

Idiosyncratic Risk, Risk-Taking Incentives and the Link between Managerial Ownership and Firm Value

We study the moral hazard problem that arises from risk-averse managers having a substantial personal investment in their companies (i.e. large equity holdings) and strong risk-substitution incentives; that is, they pass up innovative projects with high idiosyncratic (firm-specific) risk in favor of standard projects that have greater aggregate (systematic) risk. Risk-substitution incentives originate from the fact that, from a manager’s point of view, idiosyncratic risk is typically more difficult to hedge than aggregate risk. We hypothesize that while risk-substitution may help managers to diversify away their (excessive) risk exposure to their own firm, it may lead to suboptimal investment policies at a company level, offsetting the well-documented alignment effect of managerial ownership. This results into to a weak (or non-existent) association between managerial ownership and performance for firms that are exposed to severe risk-substitution problems. We test this hypothesis using parametric and semi-parametric estimation methods and report supporting evidence for it. Our results suggest that managerial ownership affects firm value in a strong positive way only for low idiosyncratic risk companies, whose managers are less likely to engage in risk-substitution. For high idiosyncratic risk companies no such link exists. Our results also reveal that the risk-substitution problem is (at least) partially mitigated by the inclusion of stock options in managerial compensation packages.

Are banks happy when managers go long? The information content of managers’ vested option holdings for loan pricing

While traditional finance theory holds that managers with option-laden incentive contracts may favor equity at the expense of debt, a risk-averse manager may be more likely to retain vested in-the-money options if the manager has private information that the firm's risk-adjusted performance will be better. It follows that vested option holdings should be positively associated with credit quality. In support of this, we find that vested option holdings have a strong negative association with loan pricing, especially for informationally sensitive loans, and also predict higher cash flows and credit ratings, a greater distance to default, and lower equity volatility.

Incentive contracts in delegated portfolio management under VaR constraint

This paper studies the incentive effect of linear performance-adjusted contracts in delegated portfolio management under a value-at-risk (VaR) constraint. It is shown that a linear performance-based contract can provide incentives for the portfolio manager to work at acquiring private information under a VaR risk constraint. The expected utility and optimal effort of a risk-averse manager are increasing functions of the return sharing ratio in the contract. However, a risk constraint causes the portfolio manager to reduce effort in gathering private information, suggesting that the VaR constraint increases the moral hazard between the investor and the manager.

Management Insights

Management Insights

Too Much Pay-Performance Sensitivity?

Abstract We examine the relation between pay-performance sensitivity (PPS), the convexity of managerial compensation (Vega), and future stock risk and returns for a large sample of firms between 1992 and 2004. Higher PPS and Vega are both associated with lower future stock returns. Part of this negative relation can be explained by risk-averse managers decreasing equity risk in response to increases in PPS and Vega. However, even after correcting for lower future risk, future stock returns are negatively associated with the magnitude of option sensitivity. This finding is consistent with previous studies that link high option compensation to manager-owner agency problems.

The Effect of Risk Preferences on the Valuation and Incentives of Compensation Contracts

In a standard principal-agent setting, we use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by managers with utility function u who are risk averse (u'' 0). We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. This is because concave contracts concentrate incentives where the marginal utility of risk averse managers is highest, while convex contracts protect against downside risk. Thus, managerial prudence can contribute to explain the prevalence of stock-options in executive compensation. However, convex contracts are not optimal when the principal is sufficiently prudent relative to the manager.

The Wage Schedule of a Risk Averse Manager in an Insurance Market

The Wage Schedule of a Risk Averse Manager in an Insurance Market

Cost-based transfer pricing under R&D risk aversion in an integrated supply chain

Abstract This paper examines the economic role of transfer pricing for a vertically integrated supply chain when a risk-averse production-division manager faces uncertainty on the outcomes from R&D investment. In particular, we compare two representative cost-based transfer pricing methods: full-cost and variable-cost pricing. We construct an economic model based on the assumption that R&D investment reduces the expected fixed costs of a production factor as well as the variable production costs. We show that a firm's profit under full-cost transfer pricing is greater than that under variable-cost transfer pricing under certainty. Contrary to this benchmark result, variable-cost pricing becomes more profitable than full-cost pricing when the risk-averse manager bears relatively high risk.

Future Firm Risks and Managers’ Personal Portfolio Decisions

Managers often have foreknowledge of events that can increase future firm risks. In this study, I examine whether managers alter their personal portfolios based on their foreknowledge. Specifically, I examine whether managers expedite or delay their stock option exercises in anticipation of increases in future stock-return volatility. The answer is not immediately obvious. On one hand, increases in future volatility may increase the value of stock options, which might motivate managers to delay their option exercises. On the other hand, higher volatility also increases the likelihood of large declines in options’ in-the-money values, risks that managers cannot easily hedge or diversify. This might motivate risk-averse managers to exercise their stock options early and invest the proceeds in less risky assets. I find that managers holding deep in-the-money options expedite their option exercises when they anticipate increases in future stock-return volatility. My study identifies a setting in which managers align their personal holdings to future firm risks, rather than align future firm risks to their personal risk appetites. I argue that the former may be beneficial to shareholders even though managers exploit their informational advantages in making their personal decisions.

Incentive Contract in Delegated Portfolio Management Under VaR Constraint

Linear contracts are popular in delegated portfolio management. This paper studies the incentive of linear performance-adjusted contracts in delegated portfolio management under a VaR constraint with a principal-agent model and numerical analysis. It is shown that a linear performance-based contract provides incentives to a portfolio manager to work at acquiring private information under a total risk constraint. The expected utility and optimal effort are increasing functions of the return sharing ratio for a risk-averse manager. However, a risk constraint makes a portfolio manager to reduce effort in gathering private information, suggesting that the VaR constraint increases the moral hazard between the investor and the manager.

Tailoring seasonal climate forecasts for hydropower operations

Abstract. Integration of seasonal precipitation forecasts into water resources operations and planning is practically nonexistent, even in regions of scarcity. This is often attributable to water manager's tendency to act in a risk averse manner, preferring to avoid consequences of poor forecasts, at the expense of unrealized benefits. Convincing demonstrations of forecast value are therefore desirable to support assimilation into practice. A dynamically linked system, including forecast, rainfall-runoff, and hydropower models, is applied to the upper Blue Nile basin in Ethiopia to compare benefits and reliability generated by actual forecasts against a climatology-based approach, commonly practiced in most water resources systems. Processing one hundred decadal sequences demonstrates superior forecast-based benefits in 68 cases, a respectable advancement, however benefits in a few forecast-based sequences are noticeably low, likely to dissuade manager's adoption. A hydropower sensitivity test reveals a propensity toward poor-decision making when forecasts over-predict wet conditions. Tailoring the precipitation forecast to highlight critical dry forecasts minimizes this inclination, resulting in 97% of the sequences favoring the forecast-based approach. Considering managerial risk preferences for the system, even risk-averse actions, if coupled with forecasts, exhibit superior benefits and reliability compared with risk-taking tendencies conditioned on climatology.

The Effect of Risk on the CEO Market

This article presents a market equilibrium model of CEO assignment, pay, and incentives under risk aversion and moral hazard. Each of the three outcomes can be summarized by a single closed-form equation. In the presence of moral hazard, assignment is distorted from positive assortative matching on firm size as firms with higher risk or disutility choose less talented CEOs. Such firms also pay higher salaries in the cross-section, but economywide increases in risk or the disutility of being a CEO do not affect pay. The strength of incentives depends only on the disutility of effort and is independent of risk and risk aversion. If the CEO can affect firm risk, incentives rise and are increasing in risk and risk aversion. We calibrate the losses from various forms of poor corporate governance, such as failures in monitoring and inefficiencies in CEO assignment. ( JEL G34, J33) This article presents a market equilibrium model of CEO assignment, pay, and incentives. Risk-averse managers of different talents are hired in a competitive market by heterogeneous firms, which vary in their size, risk, and level of effort required. The level of pay drives the assignment of talent to firms. The strength of incentives induces the efficient effort level, and is determined by an optimal contracting approach. Our main contribution is to incorporate risk into a CEO market equilibrium in a tractable manner. A large empirical literature has shown that risk is a firstorder determinant of compensation contracts (Demsetz and Lehn 1985; Garen 1994; Core and Guay 1999; Oyer and Schaefer 2004; Peters 2009; Peters and Wagner 2009), but most theories assume risk-neutrality. This assumption is

An Examination Of The Effectiveness Of CEO Stock Option Granting Decisions Toward R&D Investments?

Stock options are used to motivate investments in risky projects, such as R&D investments. When compensation committees make granting decisions to stimulate R&D spending, they should consider the following firm characteristics: (1) a firm’s growth opportunities; (2) a firm’s financial leverage; and (3) the CEO’s stock ownership prior to stock option grants. This paper addresses the effectiveness of CEO stock option granting decisions by examining whether compensation committees take these three factors into account. Using a recent sample over the period of 1992-2006, we find that firms with greater growth opportunities and firms in lower financial leverage are more likely to award CEO stock options to motivate R&D investment. These findings are consistent with that options are designed effectively to motivate managerial risk taking, thereby aligning the interests of managers with those of shareholders. However, contrary to our prediction, compensation committees tend to grant more to CEOs with larger stock ownership to induce R&D spending. A potential explanation for this finding is that CEOs with relatively large stock ownership affect the granting process and grant themselves with excessive stock options. Taken together, the evidence of CEO stock option granting process partially supports the notion that firms make effective stock option plans to mitigate incentive problems of risk-averse managers.

Dynamic Risk Taking with Bonus Schemes

This paper studies dynamic risk taking by a risk-averse manager who receives a bonus; the company may default on its contractual obligations (debt, fixed compensation). We show that risk-taking is time-independent, and is summarized by the so-called risk-aversion of derived utility. We highlight the importance of dynamic aspects and provide a foundation for common qualitative discussions that are based on characteristics of bonus functions. The paper cautions that deferral of fixed compensation may increase risk taking. Finally, we motivate a new bonus scheme that incentivizes the manager to implement the socially optimal risk level.

Financial Capital and the Macroeconomy: Policy Considerations

We develop a macroeconomic model in which the balance sheet/liquidity condition of financial institutions plays an important role in the determination of asset prices and economic activity. The financial intermediaries in our model are required to make investment commitments before a complete resolution of idiosyncratic funding risk that can be addressed only by costly refinancing, forcing them to behave in a risk-averse manner. The model shows that the balance sheet condition of intermediaries can drive asset values away from their fundamentals, causing aggregate investment and output to respond to shocks to intermediaries. We use this model to evaluate several public policies designed to address balance sheet problems at financial institutions. With regard to short-run policies, we find that capital injections conditioned upon voluntary recapitalization can be a more effective tool than direct lending/asset purchases. With regard to long-run policies, we demonstrate that higher capital requirements can have sizable short-run effects on economic activity if not implemented carefully, and that a long transition period helps avoid such effects.

Financial Capital and the Macroeconomy: Policy Considerations

We develop a macroeconomic model in which the balance sheet/liquidity condition of financial institutions plays an important role in the determination of asset prices and economic activity. The financial intermediaries in our model are required to make investment commitments before a complete resolution of idiosyncratic funding risk that can be addressed only by costly refinancing, forcing them to behave in a risk-averse manner. The model shows that the balance sheet condition of intermediaries can drive asset values away from their fundamentals, causing aggregate investment and output to respond to shocks to intermediaries. We use this model to evaluate several public policies designed to address balance sheet problems at financial institutions. With regard to short-run policies, we find that capital injections conditioned upon voluntary recapitalization can be a more effective tool than direct lending/asset purchases. With regard to long-run policies, we demonstrate that higher capital requirements can have sizable short-run effects on economic activity if not implemented carefully, and that a long transition period helps avoid such effects.

Financial Capital and the Macroeconomy: A Quantitative Framework

Financial intermediation transforms short-term liquid assets into long-term capital assets. As a result, risk taking, in the form of long-term commitments despite unresolved short-term funding risk, is an essential element of intermediation. If such funding risk must be addressed by costly recapitalization and/or distressed asset sales due to capital market frictions, an increase in uncertainty can cause a disruption in the intermediation process by forcing risk-neutral intermediaries to behave in a risk-averse manner. Our analysis examines this behavior theoretically and empirically. We first develop a dynamic macroeconomic model in which the balance sheet/liquidity condition of financial intermediaries plays an important role in the determination of asset prices and economic activity under time-varying uncertainty. Second, we present new evidence on the importance of uncertainty facing financial intermediaries for credit terms and volume and for aggregate economic activity, thereby partially quantifying the significance of capital market frictions. We adopt a structural identification strategy in which the predictions of our theory, in the form of sign restrictions, play an important role.

Financial Capital and the Macroeconomy: A Quantitative Framework

Financial intermediation transforms short-term liquid assets into long-term capital assets. As a result, risk taking, in the form of long-term commitments despite unresolved short-term funding risk, is an essential element of intermediation. If such funding risk must be addressed by costly recapitalization and/or distressed asset sales due to capital market frictions, an increase in uncertainty can cause a disruption in the intermediation process by forcing risk-neutral intermediaries to behave in a risk-averse manner. Our analysis examines this behavior theoretically and empirically. We first develop a dynamic macroeconomic model in which the balance sheet/liquidity condition of financial intermediaries plays an important role in the determination of asset prices and economic activity under time-varying uncertainty. Second, we present new evidence on the importance of uncertainty facing financial intermediaries for credit terms and volume and for aggregate economic activity, thereby partially quantifying the significance of capital market frictions. We adopt a structural identification strategy in which the predictions of our theory, in the form of sign restrictions, play an important role.

Technological change and the growing inequality in managerial compensation

Three of the most fundamental changes in US corporations since the early 1970s have been (1) the increased importance of organizational capital in production, (2) the increase in managerial income inequality and pay-performance sensitivity, and (3) the secular decrease in labor market reallocation. Our paper develops a simple explanation for these changes: a shift in the composition of productivity growth away from vintage-specific to general growth. This shift has stimulated the accumulation of organizational capital in existing firms and reduced the need for reallocating workers to new firms. We characterize the optimal managerial compensation contract when firms accumulate organizational capital but risk-averse managers cannot commit to staying with the firm. A calibrated version of the model reproduces the increase in managerial compensation inequality and the increased sensitivity of pay to performance in the data over the last three decades. This increased sensitivity of compensation to performance provides large, successful firms with the glue to retain their managers and the organizational capital embedded in them.

Dynamic Managerial Compensation: A Mechanism Design Approach

We characterize the optimal incentive scheme for a manager who faces costly eort decisions and whose ability to generate pro…ts for the …rm varies stochastically over time. The optimal contract is obtained as the solution to a dynamic mechanism design problem with hidden actions and persistent shocks to the agent's productivity. When the agent is risk-neutral, the optimal contract can often be implemented with a simple pay package that is linear in the …rm's pro…ts. Furthermore, the power of the incentive scheme typically increases over time, thus providing a possible justi…cation for the frequent practice of putting more stocks and options in the package of managers with a longer tenure in the …rm. In contrast to other explanations proposed in the literature (e.g., declining disutility of eort or career concerns), the optimality of seniority-based reward schemes is not driven by variations in the agent's preferences or in his outside option. It results from an optimal allocation of the manager's informational rents over time. Building on the insights from the risk-neutral case, we then explore the properties of optimal incentive schemes for risk-averse managers. We …nd that, other things equal, risk-aversion reduces the bene…t of inducing higher eort over time. Whether (risk-averse) managers with a longer tenure receive more or less high-powered incentives than younger ones then depends on the interaction between the degree of risk aversion and the dynamics of the impulse responses for the shocks to the manager's type.