Decision Sciences Journal
Volume 29, Number 2
Spring 1998

A Risk-sharing Approach to Transfer Pricing and Incentive Compensation Problems under Exchange Rate Uncertainty

Massood Yahya-Zadeh
Georgetown School of Business, Georgetown University, Washington, DC 20057, email: yahyazam@gunet.georgetown.edu

Abstract: This study examines the transfer pricing and incentive compensation problems in a multinational enterprise facing currency risk. It is shown that, in the presence of diverse risk preferences among managers, the Hirshleifer (1956) transfer pricing rule results in inefficient resource allocation decisions by division managers. Following the approach developed by Kanodia (1979), two transfer pricing and compensation systems are proposed. The proposed systems enable central management to achieve efficient resource allocation and partial or global risk sharing. It is also argued that the proposed plans can be implemented in conjunction with existing transfer pricing systems that primarily serve tax and tariff concerns.

Subject Areas: Incentive Compensation, Risk Sharing, and Transfer Pricing.