A Parametric Curve Analysis for the Risk-Return Tradeoff in an Agency Problem

This paper proposes a simple analysis for examining an agent's optimal decisions in a principal-agency problem. Unlike the standard approach, the target firm's expected return and risk are modeled as a parametric curve in terms of a critical business decision. A general condition is derived for characterizing how a risk-averse or risk-seeking agent may behave differently from a risk-neutral decision maker. This general theorem is applied to solve several examples that demonstrate the impacts of different types of uncertainty and illustrate several cases in which the agent may respond to incentive contracts in a counterintuitive direction