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Abstract :
[en] Classic financial agency theory recommends compensation through stock options rather than shares
to induce risk neutrality in otherwise risk averse agents. In an experiment, we find that subjects
acting as executives do also take risks that are excessive from the perspective of shareholders if
compensated through options. Compensation through restricted company stock reduces the uptake
of excessive risks. Even under stock-ownership, however, experimental executives continue to take
excessive risks—a result that cannot be accounted for by classic incentive theory. We develop a
basic model in which such risk-taking behavior is explained based on a richer array of risk attitudes
derived from Prospect Theory. We use the model to derive hypotheses on what may be driving
excessive risk taking in the experiment. Testing those hypotheses, we find that most of them are
indeed borne out by the data. We thus conclude that a prospect-theory-based model is more apt at
explaining risk attitudes under different compensation regimes than traditional principal-agent
models grounded in expected utility theory.