Ingolf Dittmann is Professor in Finance at Erasmus University Rotterdam. This post is based on a recent article by Professor Dittman; Ko-Chia Yu, Assistant Professor at National Chiayi University; and Dan Zhang, Associate Professor at BI Norwegian Business School. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here); and Regulating Bankers’ Pay by Lucian Bebchuk and Holger Spamann (discussed on the Forum here).
There is an extensive theoretical discussion whether risk-taking incentives play a role in executive pay. In our article How Important are Risk-Taking Incentives in Executive Compensation? forthcoming in the Review of Finance), we analyse the problem with a calibration of a principal-agent model to observed contracts. We show that including risk-taking incentives does help to explain observed compensation practice. We also show that the provision of risk-taking incentives is consistent with efficient contracting. Besides, our model rationalizes the universal use of at-the-money options, which is often seen as evidence for managerial rent-extraction. In addition, we propose a new measure of risk-taking incentives (available online) that better describes the trade-off between the expected firm value and the additional risk a CEO has to take.