Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/108606
Authors: 
Ozdenoren, Emre
Yuan, Kathy
Year of Publication: 
2012
Series/Report no.: 
Koç University-TÜSİAD Economic Research Forum Working Paper Series 1222
Abstract: 
We propose a new theory of suboptimal risk-taking based on contractual externalities. We examine an industry with a continuum of firms. Each firm's manager exerts costly hidden effort. The productivity of effort is subject to systematic shocks. Firms' stock prices reflect their performance relative to the industry average. In this setting, stock-based incentives cause complementarities in managerial effort choices. Externalities arise because shareholders do not internalize the impact of their incentive provision on the average effort. During booms, they over-incentivise managers, triggering a rat-race in effort exertion, resulting in excessive risk relative to the second-best. The opposite occurs during busts.
Subjects: 
Stock-Based Incentives
Excessive Risk-Taking
Insufficient Risk-Taking
Contractual Externalities
JEL: 
D86
G01
G30
Document Type: 
Working Paper

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