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Executive Compensation

Paper Session

Friday, Jan. 6, 2017 1:00 PM – 3:00 PM

Sheraton Grand Chicago, Chicago Ballroom VIII
Hosted By: American Finance Association
  • Chair: Kelly Shue, University of Chicago

Relative Pay for Non-Relative Performance: Keeping Up With the Joneses With Optimal Contracts

Peter DeMarzo
,
Stanford University
Ron Kaniel
,
University of Rochester

Abstract

We consider a multi-agent contracting setting when agents derive utility based in part on their pay relative to their peers. Because agents’ productivity is affected by common as well as idiosyncratic shocks, it is optimal to base pay on the agent’s performance relative to a benchmark of peers. But when agents have “keeping up with the Joneses” (KUJ) preferences and care about how their pay compares to that of others, relative performance evaluation also increases agents’ perceived risk. We show that when a single principal (or social planner) can commit to a public contract, the optimal contract hedges the risk of the agent’s relative wage without sacrificing efficiency. While output is unchanged, however, hedging makes the contracts appear inefficient in the sense that performance is inadequately benchmarked. We also show that when there are multiple principals, or the principal is unable to commit, efficiency is undermined. In particular, KUJ effects induce agents to be more productive, but average wages increase even more, reducing firm profits. We also show that if the principal cannot commit not to privately renegotiate contracts, then wages and effort are increased when KUJ effects are weak, but are reduced, enhancing efficiency, when KUJ effects are sufficiently strong. Finally, public disclosure of contracts across firms can cause output to collapse.

Insider Purchases after Short Interest Spikes: A False Signaling Device?

Chattrin Laksanabunsong
,
Zacks Investment Management
Wei Wu
,
Texas A&M University

Abstract

We study the information contents of the purchases by corporate insiders when their firms experience sharp increases in short interest. The cumulative abnormal returns associated with these insider purchases increase in the short run but fall back to zero afterwards. This hump-shaped pattern in the cumulative abnormal returns is more pronounced in various situations when insiders have more incentive to engage in false signaling. Insiders incur some trading losses from their purchases. However, these losses are largely outweighed by the benefits they gain from increased compensation and extended tenure. Our results suggest corporate insiders, provided with the right incentive, can strategically use open market purchases to boost stock prices, which may lead to disruption of market efficiency.

Performance-Vesting Provisions in Executive Compensation

Carr Bettis
,
Arizona State University
John Bizjak
,
Texas Christian University
Jeffrey Coles
,
University of Utah
Swaminathan Kalpathy
,
Texas Christian University

Abstract

The usage of performance vesting (p-v) equity awards to top executives in large US companies has grown from 20 to 70 percent from 1998 to 2012. We assess the implications of these increasingly complex awards by examining the accuracy of and biases in disclosure and the connection between the structure of executive pay, risk-taking incentives, and firm risk. To do so, we develop and implement new methods that empirically quantify the significant effects of p-v provisions on the value, delta, and vega of equity-based compensation. We find large biases in the value of executive compensation reported in company disclosures. The elasticity of reported value in economic value is far less than one, with additional bias downward (upward) for large institutional ownership (when the firm uses a high-market-share compensation consultant). Our analysis empirically reaffirms the presence of a causal relation in both the time series and cross section between compensation convexity and firm risk.

The Value of Information for Contracting

Pierre Chaigneau
,
Queen's University
Alex Edmans
,
London Business School
Daniel Gottlieb
,
Washington University-St. Louis

Abstract

More precise information reduces contracting costs, but is costly. This paper uses an optimal contracting model to study how contracts change with information precision, allowing us to quantify the cost savings and identify where information is most valuable. One application is to employment, where the optimal contract is an option. The direct effect of reducing signal volatility is a fall in the option's value, which benefits the principal. The indirect effect is a change in effort incentives. If the original option is sufficiently out-of-the-money (the agency problem is weak), the agent can only beat the strike price if he exerts effort and there is a high noise realization. Thus, a fall in volatility reduces effort, lowering the value of information and potentially justifying pay-for-luck. In contrast, standard option theory suggests that lower volatility has greatest effect for at-the-money options, i.e. moderate agency problems. A second application is to financing, where the optimal contract is debt. The model has implications for when monitoring by the lender is most valuable, and for a firm's ability to raise external financing.
Discussant(s)
Florian Ederer
,
Yale University
Karl Diether
,
Brigham Young University
Katharina Lewellen
,
Dartmouth College
Dmitry Orlov
,
University of Rochester
JEL Classifications
  • G3 - Corporate Finance and Governance