Risk-Return Tradeoffs and Managerial Incentives

Moral hazard theory posits that managerial risk aversion imposes agency costs on shareholders, and firms respond by providing risk-taking incentives to mitigate these costs. An underlying assumption in this literature is that increasing shareholder value requires increasing risk, yet there is limited empirical evidence supporting this assumption or the role of such risk-return tradeoffs in incentive compensation design. Using measures based on the firm’s stock price, I find that shareholder value increases with risk, consistent with managerial risk aversion reducing shareholder value. I also find that firms implement compensation contracts with stronger risk-taking incentives when potential risk-related agency costs are more severe, particularly among firms where value increases with idiosyncratic rather than systematic risk and whose managers are more risk-averse. Overall, these results are consistent with firms designing executive compensation contracts to help manage risk-related agency costs. Additional findings highlight how the incentive effects of equity-based compensation depend on firms’ risk-return tradeoffs, providing one explanation for conflicting results in prior literature regarding how managers’ stock holdings affect their investment decisions.