A Tale of Paper

Certainty Equivalent and Risk Premium

Figure 2.9 indicates that Taylor is indifferent between the risky commission scheme, which has an expected payoff of $100,000, and a certain income of $80,000. The $80,000 is Taylor’s certainty equivalent for the risky income stream—he is willing to trade the uncertain income of $100,000 for a certain income of $80,000. The difference between the expected value of the risky income stream and the certainty equivalent is called the risk premium. This $20,000 premium, which comes in the form of a higher expected payoff, must be paid to keep Taylor indifferent between the risky income stream and his certainty equivalent.

Suppose that Taylor receives a job offer from a competing real estate company that would pay him a fixed salary of $90,000 per year. Taylor considers the new job to be the same as his current job in all dimensions other than the compensation plan. Taylor’s current compensation plan will not be sufficient to motivate him to continue to work for RealCo. Even though his current plan has a higher expected payoff, he would prefer the certain $90,000 to RealCo’s risky commission plan. If RealCo wants to retain Taylor, it must offer him a compensation package that provides the same level of utility as the $90,000 for certain.

Risk Aversion and Compensation

Diversified shareholders, who invest in portfolios of companies, own much of the stock of large firms. Managers are often ill-diversified, having much of their human and financial capital invested in one firm. As we will discuss later in this book, this difference in diversification can lead to managers being overly risk averse in their investment deci- sions relative to those shareholders would prefer. Shareholders can induce managers to

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Summary

Basic Concepts

undertake more risky investment by adopting compensation plans that reward good outcomes, but that do not...