Preference dynamics and risk-taking incentives

Abstract

This study explores the relationship between executive compensation and the preference dynamics of managers and shareholders. Our analysis centers on the theoretical prediction that changes in firms' asset value can differentially affect the risk-taking preferences of the two groups, potentially influencing the optimal compensation policy. Utilizing local real estate price changes to identify variations in firms’ asset value, we find that a decrease in asset value leads to more risk-taking incentives in compensation, and this effect is more pronounced in firms that are more likely to be influenced by the hypothesized mechanisms. In the second empirical setting, we provide corroborating evidence using a natural experiment involving disaster-induced negative shocks to the firm fundamentals. Collectively, our findings suggest that the design of compensation contracts facilitates incentive alignment by incorporating the dynamic preferences of the contracting parties.