Working Paper: CEPR ID: DP7442
Authors: Lin Peng; Ailsa A. Rell
Abstract: This paper presents a rational expectations model of optimal executive compensation in a setting where managers are in a position to manipulate short-term stock prices, and managers' propensity to manipulate is uncertain. Stock-based incentives elicit not only productive effort, but also costly information manipulation. We analyze the tradeoffs involved in conditioning pay on long- versus short-term performance and characterize a second-best optimal compensation scheme. The paper shows manipulation, and investors' uncertainty about it, affects the equilibrium pay contract and the informational efficiency of asset prices. The paper derives a range of new cross-sectional comparative static results and sheds light on corporate governance regulations.
Keywords: Corporate Governance; Executive Compensation; Long versus Short-term; Manipulation; Uncertainty
JEL Codes: D8; G30; G34; J33; J41; K2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Executive compensation structures that are highly sensitive to short-term stock prices (M52) | productive effort (E23) |
| Executive compensation structures that are highly sensitive to short-term stock prices (M52) | costly information manipulation (D82) |
| Uncertainty regarding managers' propensity to manipulate stock prices (D89) | informational inefficiencies in stock prices (G14) |
| Increasing manipulation uncertainty (D89) | compensation contracts to be more sensitive to short-term stock prices (J33) |
| Long-term incentives (M52) | mitigate adverse effects of short-term manipulation (E71) |
| Executive compensation structures that are highly sensitive to short-term stock prices (M52) | stock price dynamics (C69) |
| Manipulation uncertainty (D80) | strength of incentives (M52) |