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Title: Stock Market Tournaments

Author(s): Emre Ozdenoren and Kathy Yuan

Publication Date: June 2012

Keyword(s): Contractual Externalities, Excessive Risk-Taking, Insufficient Risk-Taking and Stock-Based Incentives

Programme Area(s): Financial Economics and Industrial Organization

Abstract: We propose a new theory of suboptimal risk-taking based on contractual externalities. We examine an industry with a continuum of firms. Each firm's manager exerts costly hidden effort The productivity of effort is subject to systematic shocks. Firms' stock prices reflect their performance relative to the industry average. In this setting, stock-based incentives cause complementarities in managerial effort choices. Externalities arise because shareholders do not internalize the impact of their incentive provision on the average effort. During booms, they over-incentivise managers, triggering a rat-race in effort exertion, resulting in excessive risk relative to the second-best. The opposite occurs during busts.

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Bibliographic Reference

Ozdenoren, E and Yuan, K. 2012. 'Stock Market Tournaments'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9000