Dynamic Risk Taking with Bonus Schemes
35 Pages Posted: 5 Feb 2011 Last revised: 12 May 2014
Date Written: May 12, 2014
This paper studies dynamic risk taking by a risk-averse manager who receives a bonus; the company may default on its contractual obligations (debt, fixed compensation). We show that risk-taking is time-independent, and is summarized by the so-called risk-aversion of derived utility. We highlight the importance of dynamic aspects and provide a foundation for common qualitative discussions that are based on characteristics of bonus functions. The paper cautions that deferral of fixed compensation may increase risk taking. Finally, we motivate a new bonus scheme that incentivizes the manager to implement the socially optimal risk level.
Keywords: Bonus, Risk, Incentives, Options
JEL Classification: G11, G13, G32
Suggested Citation: Suggested Citation