As part of the series of the "Finance Research Seminar", VGSF welcomes Paolo Fulghieri from UNC Kenan-Flagler Business School to present his research paper.
Uncertainty, Contracting, and Beliefs in Organizations
We examine a multidivisional firm with headquarters exposed to moral hazard by division managers under ambiguity aversion. We show the aggregation and linearity properties of Holmström and Milgrom (1987) hold under IID ambiguity of Chen and Epstein (2002). Due to uncertainty aversion, agents' beliefs depend endogenously on their exposure to uncertainty, either for their position in the organization (hierarchical exposure) or contracts (contractual exposure). Incentive contracts, by loading primarily on division cash-flow, lead division managers to be more conservative than headquarters, aggravating moral-hazard. By hedging uncertainty, headquarters can design contracts that reduce disagreement, lower incentive provision costs, and promote effort. Because hedging uncertainty can conflict with hedging risk, optimal contracts can differ substantially from those in standard principal-agent models. Our model helps explain the prevalence of equity-based incentive contracts and the rarity of relative-performance contracts.