Title: A Missing Link in the Risk-Incentive Tradeoff
Reference Number: 1140
Publication Date: May 2005
JEL Classifcation: D80, G14, G32, J33

Qiang Kang
University of Miami

Qiao Liu
The University of Hong Kong

We investigate the role of information-based trading in affecting the risk-incentive relation. We analytically decompose the risk-incentive relation into two o setting components. Directly reducing incentive aside, a greater uncertainty increases the level of information-based trading which enhances incentives indirectly. Numerical analysis shows that the indirect effect is about 40-50% of the direct effect in size and contributes significantly to social welfare improvement. Empirical tests using probability of informed trading (PIN) and CEO compensation data show that a median level of information-based trading on average causes a 20% offset of the risk-incentive tradeoff and improves CEO incentives by 15-96%.

Key words: Risk-incentive tradeoff, information-based trading, pay-performance sensitivity, PIN measure

Last modified: 06/28/2005