Optimal Contracts with Hidden Risk∗

Several episodes in recent years have highlighted the problem of managers subjecting their firms to large risks. We develop a dynamic moral hazard model where a manager’s diversion of funds is indistinguishable from random shocks. In addition, he also takes unobservable actions which yield certain current payoffs, but expose the firm to large negative shocks. We show that standard pay-for-performance contracts, which are typically beneficial under moral hazard, may lead the manager to take on excess risk. We then characterize the optimal contract taking into account incentive provision and risk management. We solve two examples. One is explicitly solvable, and we show how the contract can be implemented with simple instruments. The owner gives the manager a constant salary payment and allows him to manage the ex-dividend assets of the firm, but imposes a “clawback” fee in the event of large negative shocks. The second example shows that it may sometimes be optimal for the owner to forgo risk management and allow the manager to take excess risk.