Risk-Return Tradeoffs and Managerial incentives
Finance and Financial Management
Moral hazard theory posits that managerial risk aversion imposes agency costs on shareholders, and firms respond by providing risk-taking incentives to mitigate these costs. The underlying assumption in this literature is that increasing shareholder value requires increasing risk, yet there is limited empirical evidence supporting this assumption or the role of such risk-return tradeoffs in incentive compensation design. Using measures based on the firm’s stock price, I find that shareholder value increases with risk, consistent with managerial risk aversion imposing agency costs on shareholders. I also find that firms provide managers with more risk-taking incentives when this risk-return relation is more positive and thus potential risk-related agency costs are more severe. This finding is strongest among firms where value increases with idiosyncratic rather than systematic risk, consistent with theory that these agency costs arise primarily from managers’ exposure to idiosyncratic risk. Overall, these results are consistent with firms designing managerial compensation contracts to mitigate risk-related agency costs. Additional findings highlight that the incentives from equity-based compensation depend on the risk-return tradeoffs that managers face, providing one explanation for the conflicting results in prior literature regarding the incentives from managerial stock price exposure.