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We consider a model in which shareholders provide a risk-averse CEO with risk-taking incentives in addition to effort incentives. We show that the optimal contract protects the CEO from losses for bad outcomes, is convex for medium outcomes, and concave for good outcomes. We calibrate the model to data on 1,707 CEOs and show that it explains observed contracts much better than the standard model without risk-taking incentives. An application to contracts that consist of base salary, stock, and options yields that options should be issued in the money. Our model also helps us rationalize the universal use of at-the-money options when the tax code is taken into account. Moreover, we propose a new measure of risk-taking incentives that trades off the expected value added to the firm and the additional risk a CEO has to take.

Published in

Review of Finance
Volume 21, Issue 5, 1 August 2017, Pages 1805–1846

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