Risk-Incentives Trade-Off and Outside Options

OR Spectrum, 2012

23 Pages Posted: 27 Nov 2012

See all articles by Ying-Ju Chen

Ying-Ju Chen

Hong Kong University of Science & Technology (HKUST) - Department of Information Systems, Business Statistics and Operations Management

Date Written: November 26, 2012

Abstract

Despite the prominence of the risk-incentives trade-off in the agency theory, empirical evidence provides at best a mixed result. In this paper, we argue that these mixed results may be attributed to the heterogeneity of risk aversion magnitude among the agents and the outside options available on the market. We show that when an increase of the uncertainty amplifies the riskiness of principal's internal project more than the agent's outside option, a positive risk-incentives relationship can be predicted when the internal project is sufficiently risky. On the other hand, when an uncertainty increase amplifies the riskiness of outside option more than the internal project, this positive risk-incentives relationship occurs if the internal project is of limited risk. These results hold irrespective of whether the agent's risk aversion magnitude is publicly observable or privately known. Our analysis leads to a more fine-tuned empirical validation of agency theory and some testable hypotheses on the interactions between internal and external uncertainties.

Keywords: risk-incentives trade-off, compensation, mechanism design, game theory

Suggested Citation

Chen, Ying-Ju, Risk-Incentives Trade-Off and Outside Options (November 26, 2012). OR Spectrum, 2012, Available at SSRN: https://ssrn.com/abstract=2181220

Ying-Ju Chen (Contact Author)

Hong Kong University of Science & Technology (HKUST) - Department of Information Systems, Business Statistics and Operations Management ( email )

Clear Water Bay
Kowloon
Hong Kong

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