An Equilibrium Model of Asset Pricing and Moral Hazard
49 Pages Posted: 23 Oct 2002
Date Written: December 15, 2002
This paper develops an integrated model of asset pricing and moral hazard. In particular, we combine a version of the Capital Asset Pricing Model (CAPM) with a multi-agent moral hazard model. The excess returns for risky assets, optimal contracts for managers (agents) that involve relative performance, and equilibrium asset prices are explicitly characterized. We show that the CAPM linear relation still holds in the presence of moral hazard and that our beta is given by the ratio of the covariance between a firm's asset return and the market return over the variance of the market return, with both returns adjusted for the compensation to the managers. An empirical implication of the model is that there exists a negative relationship between an asset's return and its manager's pay-performance sensitivity. Furthermore, after controlling for certain factors, there exists a positive relationship between an asset's return and its idiosyncratic risk. We also show that the risk aversion of the principal in our model leads to less emphasis on relative performance evaluation than in a model with a risk-neutral principal. This result may shed light on why the empirical evidence for relative performance evaluation is mixed, even though the theoretical prediction based on a risk-neutral principal strongly supports it.
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