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The Review of Financial Studies

Uncertainty, Contracting, and Beliefs in Organizations

The Review of Financial Studies
Volume Issue
Volume 38, Number 7
Page range
pp. 2182–2225
Date published:
Published Article
Working paper version
Abstract

Abstract We study the impact of uncertainty on optimal contracting in a multidivisional firm. Headquarters contract with division managers to induce effort. Uncertainty creates endogenous disagreement, thereby aggravating moral hazard. By hedging uncertainty, headquarters design incentive contracts that reduce disagreement and lower incentive provision costs, thereby promoting effort. Because hedging uncertainty can conflict with hedging risk, optimal contracts differ from those in standard principal-agent models. Our model helps explain the prevalence of equity-based incentive contracts and the rarity of relative-performance contracts, especially in firms facing greater uncertainty.

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