Finance and Economics Discussion Series

Uncertainty, Risk, and Incentives: Theory and Evidence

Zhiguo He, Si Li, Bin Wei, and Jianfeng Yu
2013-18

Abstract: Uncertainty has qualitatively different implications than risk in studying executive incentives. We study the interplay between profitability uncertainty and moral hazard, where profitability is multiplicative with managerial effort. Investors who face greater uncertainty desire faster learning, and consequently offer higher managerial incentives to induce higher effort from the manager. In contrast to the standard negative risk-incentive trade-off, this "learning-by-doing" effect generates a positive relation between profitability uncertainty and incentives. We document empirical support for this prediction.

Keywords: Executive compensation, optimal contracting, learning, uncertainty, risk-incentive trade-off