“A Missing Link in the Risk-Incentive Tradeoff” by Qiang KANG
Authors:
Qiang KANG
University of Hong KongQiao LIU
University of Hong Kong
We investigate in this paper the risk-incentive relationship by developing an information-based optimal contracting model. We employ a market microstructure model with multiple informed traders for information production. The risk-incentive relationship is analytically decomposed into two components: one measures the traditional risk-incentive tradeoff (given the market informativeness level), and the other reflects the incentive enhancement as a result of more stock market information production driven by a higher uncertainty. The second component is strictly dominated and the overall risk-incentive tradeoff holds, reaffirming standard agency theory predictions. The information enhancement effect contributes to a significant welfare improvement. Cross-sectional differences in the information enhancement effect, missing from the existing literature, generate cross-sectional variations in incentives. Taking into account this missing link can potentially resolve the empirical ambiguity in the risk-incentive relationship and offer a sound explanation on the seemingly counter-intuitive anecdotes. Our model has an implication for the connection between stock market efficiency and economic efficiency and for the weak evidence of relative performance evaluation models.
