Uncertainty, investment, and managerial incentives

This study provides evidence that managerial incentives, shaped by compensation contracts, help to explain the empirical relationship between uncertainty and investment. We develop a model in which the manager, compensated with an equity-based contract, makes investment decisions for a firm that faces time-varying volatility. The contract creates incentives that affect both the sign and magnitude of a manager׳s optimal response to volatility shocks. The model is calibrated using compensation data to quantify this predicted investment response for a large panel of firms. Our estimates help explain the variation in firm-level investment responses to volatility shocks observed in the data. •Compensation contracts impact the manager׳s investment response to uncertainty shocks.•Develop a model to map compensation contracts to privately optimal investment choices.•Find variation in the sign and magnitude of responses to uncertainty shocks.•Model estimates explain the variation in empirical investment response to uncertainty.