Optimal risk trade-off in relative performance evaluation

Martin G.H. Wu

Research output: Contribution to journalArticlepeer-review


In this study, I consider a company’s optimal use of relative performance evaluation (RPE) in principal/ agent relations to filter out common risk. I construct a risk-parity aggregate of the company’s peer group to be the sum of the ratios of the common-and idiosyncratic-risk components of the group of peers’ outputs, scaled by the variance of the common risk. I demonstrate that this aggregate embodies the peer group’s informativeness about the common risk, so it captures precisely the group’s innate capability to trade off optimally between the common-and idiosyncratic-risk components of those peers’ outputs. The optimal use of RPE therefore entails a partial substitution of the common risk with the peers’ idiosyncratic risks. Moreover, the risk-parity aggregate enables us to identify a boundary condition, which helps us rule out ineffective uses of RPE that completely eliminate the common risk, thereby improving the statistical power of a strong-form RPE test.

Original languageEnglish (US)
Pages (from-to)247-259
Number of pages13
JournalJournal of Management Accounting Research
Issue number1
StatePublished - Mar 1 2019


  • Common versus idiosyncratic risk trade-off
  • Executive pay
  • Relative performance evaluation
  • Risk-parity aggregate of signals

ASJC Scopus subject areas

  • Business and International Management
  • Accounting


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