Risk Choices and Compensation Design

Carey, Mark S.; Sun, Bo

Working Paper

Risk Choices and Compensation Design

Abstract: We analyze the impact of bad-tail risks on managerial pay functions, especially the decision to pay managers in stock or in options. In contrast to conventional wisdom, we find that options are often a superior vehicle for limiting managerial incentives to take bad-tail risks while providing incentives to exert effort. Arrangements similar to collar options are able to incent the desired project choice in wider range of circumstances than call options or stock. However, information requirements appear high. We briefly explore alternatives with features similar to maluses and clawbacks, which are a bit like weakening the limited liability of managers.

Keywords: Compensation; Bad tail risk;

JEL Classification: D86; G20; G34;