Risk aversion, prudence, and compensation

Abstract

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) and prudent ( 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.