Entrepreneurial Incentives in Stock Market Economies

A Capital Asset Pricing Model of a stock market economy is examined under different corporate governance structures in which the objectives of managers and entrepreneurs in choosing the risk composition of their firms' returns are not aligned with those of shareholders and investors because of moral hazard. It is shown that incentive compensation, by exposing managers and entrepreneurs to unhedgeable firm-specific risk, induces them to change the stochastic properties of firm cash flows. Since they can trade in markets for aggregate risk but not for firm-specific risk, managers and entrepreneurs produce excessive aggregate risk compared to the first-best allocation. This results in a diversification externality for the stock market investors who cannot share the aggregate risks amongst each other as well as they can the firm-specific risks. The optimal incentive compensation designed to address such diversification externality is fully characterized and it is demonstrated that financial markets interact with the stock market in important ways in determining the effectiveness of incentive contracts in controlling the negative welfare effects of diversification externality.