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Dynamic Compensation Under Uncertainty Shocks and Limited Commitment

Published online by Cambridge University Press:  14 August 2020

Felix Zhiyu Feng Open the ORCID record for Felix Zhiyu Feng [Opens in a new window]
Felix Zhiyu Feng*
Affiliation:
University of Washington Foster School of Business
*
ffeng@uw.edu (corresponding author)
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Abstract

This article studies dynamic compensation and risk management under cash-flow volatility shocks. The optimal contract depends critically on firms’ ability to make good on promised future payments to managers. When volatility is low, firms with full commitment ability implement high pay–performance sensitivity to motivate effort from managers, and they impose large penalties on the arrival of volatility shocks to incentivize prudent risk management. In contrast, firms with limited commitment may allow excessive risk taking in exchange for low pay–performance sensitivity. When volatility becomes high, firms with full commitment defer compensation more, whereas firms with limited commitment must expedite payments.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 56 , Issue 6 , September 2021 , pp. 2039 - 2071
Copyright
© The Author(s), 2020. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

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Footnotes

This article is the main chapter of my PhD dissertation at Duke University. I am indebted to Barney Hartman-Glaser, Adriano Rampini, Curtis Taylor, and S. Viswanathan for their invaluable guidance. I thank an anonymous referee, Jennifer Conrad (the editor), Attila Ambrus, Bruno Biais, Philip Bond, Micheal Brolley, Brendan Daley, Mike Fishman, George Georgiadis, Brett Green, Dirk Jenter, Rui Li, Andrey Malenko, Philipp Sadowski, Ajay Subramanian, Alexei Tchistyi, Felipe Varas, Paolo Volpin, Mark Westerfield, and Ming Yang and seminar and conference participants at Duke University, Georgia State University, the University of Notre Dame, the University of Oxford, the University of Washington, the 2013 EFA Annual Meeting, the 2015 American Finance Association (AFA) Annual Meeting, the 2017 Northwestern Relational Contracts Conference, the 2018 Society for Economic Dynamics (SED) Annual Meeting, and the 2018 Econometric Society North American Summer Meeting (NASM) for helpful comments and suggestions. All errors are my own.

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