|Lefebvre, Mathieu and Vieider, Ferdinand M. (2011): Risk Taking of Executives under Different Incentive Contracts: Experimental Evidence. Discussion Papers in Economics 2011-7|
Classic financial agency theory recommends compensation through stock options rather than shares to induce risk neutrality in otherwise risk averse agents. In an experiment, we find that subjects acting as executives do also take risks that are excessive from the perspective of shareholders if compensated through options. Compensation through restricted company stock reduces the uptake of excessive risks. Even under stock-ownership, however, experimental executives continue to take excessive risks—a result that cannot be accounted for by classic incentive theory. We develop a basic model in which such risk-taking behavior is explained based on a richer array of risk attitudes derived from Prospect Theory. We use the model to derive hypotheses on what may be driving excessive risk taking in the experiment. Testing those hypotheses, we find that most of them are indeed borne out by the data. We thus conclude that a prospect-theory-based model is more apt at explaining risk attitudes under different compensation regimes than traditional principal-agent models grounded in expected utility theory.
|Item Type:||Paper (Discussion Paper)|
|Keywords:||prospect theory, expected utility theory, risk attitude, executive compensation, reference dependence, experimental finance|
Economics > Discussion Papers in Economics
|Subjects:||300 Social sciences > 300 Social sciences, sociology and anthropology|
300 Social sciences > 330 Economics
|JEL Classification:||D03, G28, G32, J33, L22|
|Deposited On:||12. Apr 2011 01:43|
|Last Modified:||28. Nov 2013 07:58|
Abdellaoui, Mohammed (2000). Parameter-Free Elicitation of Utility and Probability Weighting Functions. Management Science 46(1), 1497-1512.
Abdellaoui, Mohammed, Aurélien Baillon, Laetitia Placido, & Peter P. Wakker (2010). The Rich Domain of Uncertainty: Source Functions and Their Experimental Implementation. American Economic Review, forthcoming.
Abdellaoui, Mohammed, Han Bleichrodt, & Olivier L'Haridon (2008). A Tractable Method to Measure Utility and Loss Aversion under Prospect Theory. Journal of Risk and Uncertainty 36, 245-266.
Abdellaoui, Mohammed, Han Bleichrodt, & Corina Paraschiv (2007). Loss Aversion under Prospect Theory: A Parameter-Free Measurement. Management Science 53(10), 1659-1674.
Agrawal, Anup, & Gershon N. Mandelker (1987). Managerial Incentives and Corporate Investment and Financiang Decisions. Journal of Finance 42(4), 823-837.
Baucells, Manel, Martin Weber, & Frank Welfens (2011). Reference Point Formation and Updating. Management Science 57(3), 506–519.
Bebchuk, Lucian A., Alma Cohen, & Holger Spamann (2009). The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000–2008. Discussion Paper No. 657, Harvard Law School.
Bebchuk, Lucian Arye, & Jesse M. Fried (2003). Executive Compensation as an Agency Problem. Journal of Economic Perspectives 17(3), 71-92.
Benartzi, Shlomo, and Richard H. Thaler (1995). Myopic Loss Aversion and the Equity Premium Puzzle. Quarterly Journal of Economics 110(1), 75-92.
Biais, Bruno, Denis Hilton, Karine Mazurier, & Sébastien Pouget (2005). Judgmental Overconfidence, Self-Monitoring, and Trading Performance in an Experimental Financial Market. Review of Economic Studies 72, 287-312.
Bleichrodt, Han, José Luis Pinto, & Peter P. Wakker (2001). Making Descriptive Use of Prospect Theory to Improve the Prescriptive Use of Expected Utility. Management Science 47(11), 1498-1514.
Booij, Adam, Bernard M. S. van Praag, & Gijs van de Kuilen (2010). A parametric analysis of prospect theory’s functionals for the general population. Theory and Decision 68(1-2), 115–148.
Carpenter, Jennifer N. (2000). Does option compensation increase managerial risk appetite? Journal of Finance 55, 2311–2331.
Core, John E., & Wayne R. Guay (2001). Stock Option Plans for non-Executive employees. Journal of Financial Economics 61, 253-287.
Core, John E., Wayne R. Guay, & David F. Larcker (2003). Executive Equity Compensation and Incentives: A Survey. Economic Policy Review, 27-50
Chou, Pin-Huang, Robin K. Chou and Kuan-Cheng Ko (2009). Prospect theory and the risk-return paradox: some recent evidence. Review of Qunatitative Finance and Accounting 33(3), 193–208.
DeFusco, Richard A., Robert R. Johnson, & Tomas S. Zorn (1990). The Effect of Executive Stock Option Plans on Stockholders and Bondholders. Journal of Finance 45(2), 617-627.
Diecidue, Enrico, & Jeroen van de Ven (2008). Aspiration Level, Probability of Success and Failure, and Expected Utility. International Economic Review 49(2), 683–700.
Fellner, Gerlinde, & Matthias Sutter (2009). Causes, Consequences, and Cures of Myopic Loss Aversion – An Experimental Investigation. The Economic Journal 119(537), 900-916.
Feltham, Gerald A., & Martin G.H. Wu (2001). Incentive Efficiency of Stock versus Options. Review of Accounting Studies 6, 7-28.
Fiegenbaum, Avi, & Howard Thomas (1988). Attitudes toward Risk and the Risk-Return Paradox: Prospect Theory Explanations. Academy of Management Journal 31(1), 85–106.
Gneezy, Uri, Arie Kapteyn, & Jan Potters (2003). Evaluation Periods and Asset Prices in a Market Experiment. Journal of Finance 58(2), 821
Gneezy, Uri, & Jan Potters (1997). An experiment on risk taking and evaluation periods. Quarterly Journal of Economics 112, 631–646.
Greiner, Ben (2004). The Online Recruitment System ORSEE 2.0 - A Guide for the Organization of Experiments in Economics. University of Cologne, Working Paper Series in Economics 10.
Guay, Wayne R. (1999). The Sensitivity of CEO Wealth to Equity Risk: An Analysis of the Magnitude and Determinants. Journal of Financial Economics 53, 43–71.
Haigh, Michael S., & John A. List (2005). Do Professional Traders Exhibit Myopic Loss Aversion? Experimental Analysis. Journal of Finance 60(1).
Hall, Brian J., & Jeffrey B. Liebman (1998). Are CEOs really paid like beaurocrats? Quarterly Journal of Economics 113(3), 653–691.
Heath, Chip, Steven Huddart, & Mark Lang (1999). Psychological Factors and Stock Option exercise. Quarterly Journal of Economics 114(2), 601–627.
Holden, Richard T. (2005). The Original Management Incentive Schemes. Journal of Economic Perspectives 19(4), 135-144.
Jegers, Marc (1991). Prospect Theory and the Risk-Return Relation: Some Belgian Evidence. The Academy of Management Journal 34(1), 215–225.
Jensen, Michael C., & Kevin J. Murphy (1990). CEO Incentives: It's Not How Much You Pay, But How. Harvard Business Review 3, 138-153.
Kahneman, Daniel, & Amos Tversky (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica 47(2), 263-291.
Köbberling, Veronika, & Peter P. Wakker (2005). An Index of Loss Aversion. Journal of Economic Theory 122, 119-131.
Kuhn, Thomas S. (1962). The Structure of Scientific Revolutions. The University of Chicago Press: Chicago & London.
Lee, Jinkwon (2008). The effect of the background risk in a simple chance improving decision model. Journal of Risk and Uncertainty 36, 19–41.
List, John A., & Charles F. Mason (2010). Are CEOs expected utility maximizers? Journal of Econometrics, forthcoming.
Ross, Stephen A. (2004). Compensation, Incentives, and the Duality of Risk Aversion and Riskiness. Journal of Finance 64, 207–225.
Schmidt, Ulrich, & Horst Zank (2005). What is Loss Aversion? Journal of Risk and Uncertainty 30(2), 157-167.
Smith C.W., & René M. Stulz (1985). The Determinants of Firms’ Hedging Policies. The Journal of Financial and Quantitative Analysis 20(4), 391-405.
Starmer, Chris (2000). Developments in Non-Expected Utility Theory: The Hunt for a Descriptive Theory of Choice under Risk. Journal of Economic Literature 38, 332-382.
Thaler, Richard H., & Eric J. Johnson (1990). Gambling with House Money and Trying to Break Even: The Effects of Prior Outcomes on Risky Choice. Management Science 36, 643–660.
Tversky, Amos, & Daniel Kahneman (1992). Advances in Prospect Theory: Cumulative Representation of Uncertainty. Journal of Risk and Uncertainty 5, 297-323.
Wakker, Peter P. (2010). Prospect Theory for Risk and Ambiguity. Cambridge University Press, Cambridge.
Wiseman, Robert M., & Luis R. Gomez-Mejia (1998). A Behavioral Agency Model of Managerial Risk Taking. Academy of Management Review 23(1), 133–153.
Wu, George, & Richard Gonzalez (1996). Curvature of the Probability Weighting Function. Management Science 42(12), 1676-1690.
Zeiliger, R. (2000). A Presentation of Regate, Internet Based Software for Experimental Economics, http://www.gate.cnrs.fr/~zeiliger/regate/RegateIntro.ppt, GATE. Lyon: GATE.