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The Valuation of Assets under Moral Hazard




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    • Assistant Professor, Sloan School of Management, M.I.T. and Associate Professor, Indiana University/Visiting Associate Professor of Finance, J. L. Kellogg Graduate School of Management, Northwestern University, respectively. The first draft of this paper, M.I.T. WP 1248-81, was written in mid 1981 and subsequent revisions were completed while Thakor was at the Graduate School of Business, Indiana University. We would like to thank Doug Diamond and two anonymous referees for very helpful comments. The usual disclaimer concerning responsibility for errors applies.


The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of managers can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms.

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