Working Paper: CEPR ID: DP3474
Authors: Viral V. Acharya; Alberto Bisin
Abstract: A Capital Asset Pricing Model of a stock market economy is examined under different corporate governance structures in which the objectives of managers and entrepreneurs in choosing the risk composition of their firms' returns are not aligned with those of shareholders and investors because of moral hazard. It is shown that incentive compensation, by exposing managers and entrepreneurs to unhedgeable firm-specific risk, induces them to change the stochastic properties of firm cash flows. Since they can trade in markets for aggregate risk but not for firm-specific risk, managers and entrepreneurs produce excessive aggregate risk compared to the first-best allocation. This results in a diversification externality for the stock market investors who cannot share the aggregate risks amongst each other as well as they can the firm-specific risks. The optimal incentive compensation designed to address such diversification externality is fully characterized and it is demonstrated that financial markets interact with the stock market in important ways in determining the effectiveness of incentive contracts in controlling the negative welfare effects of diversification externality.
Keywords: aggregate risk; CAPM; entrepreneurship; financial innovation; hedging; idiosyncratic risk; managerial incentives; stock market efficiency
JEL Codes: D52; D62; G10; G31; G32; J33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| incentive compensation schemes (J33) | increase aggregate risk of firms' cash flows (G32) |
| increase aggregate risk of firms' cash flows (G32) | diversification externality (D62) |
| diversification externality (D62) | negatively affecting stock market investors (G10) |
| optimal incentive compensation (M52) | mitigate diversification externality (F64) |
| higher-powered compensation schemes (M52) | lower risk loadings on common market factors (G41) |