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Board of Governors of the Federal Reserve System (U.S.)
International Finance Discussion Papers
Incentive Contracting Under Ambiguity Aversion
Qi Liu
Lei Lu
Bo Sun
Abstract

This paper studies a principal-agent model in which the information on future firm performance is ambiguous and the agent is averse to ambiguity. We show that if firm risk is ambiguous, while stocks always induce the agent to perceive a high risk, options can induce him to perceive a low risk. As a result, options can be less costly in incentivizing the agent than stocks in the presence of ambiguity. In addition, we show that providing the agent with more incentives would induce the agent to perceive a higher risk, and there is a discontinuous jump in the compensation cost as incentives increase, which makes the principal reluctant to reset contracts frequently when underlying fundamentals change. Thus, compensation contracts exhibit an inertia property. Lastly, the model sheds some light on the use of relative performance evaluation, and provides a rationale for the puzzle of pay-for-luck in the presence of ambiguity.


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Qi Liu & Lei Lu & Bo Sun, Incentive Contracting Under Ambiguity Aversion, Board of Governors of the Federal Reserve System (U.S.), International Finance Discussion Papers 1195, Feb 2017.
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Keywords: Ambiguity ; Executive compensation ; Options ; Relative performance evaluation
DOI: 10.17016/IFDP.2017.1195
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