Risk–incentives trade-off and outside options

Despite the prominence of the risk–incentives trade-off in the agency theory, empirical evidence provides at best a mixed result. In this paper, we argue that these mixed results may be attributed to the heterogeneity of risk aversion magnitude among the agents and the outside options available on the market. We show that when an increase in the uncertainty amplifies the riskiness of principal’s internal project more than the agent’s outside option, a positive risk–incentives relationship can be predicted when the internal project is sufficiently risky. On the other hand, when an uncertainty increase amplifies the riskiness of outside option more than the internal project, this positive risk–incentives relationship occurs if the internal project is of limited risk. These results hold irrespective of whether the agent’s risk aversion magnitude is publicly observable or privately known. Our analysis leads to a more fine-tuned empirical validation of agency theory and some testable hypotheses on the interactions between internal and external uncertainties.