The optimal timing of executive compensation

We propose a new continuous-time principal-agent model to study the optimal timing of stock-based incentives, when the effects of managerial actions materialize with a lag and are only progressively understood by shareholders. On the one hand, early contingent compensation hedges the manager against the accumulation of exogenous shocks. On the other hand, the fact that initial information asymmetries between the manager and shareholders are progressively resolved suggests that contingent compensation should be postponed. We introduce two possible types of managerial short-termism, and show that they both result in lower-powered incentives and more deferred compensation

Aversion to the variability of pay and the structure of executive compensation contracts

This paper presents a new implication of an aversion toward the variance of pay (“risk aversion”) for the structure of managerial incentive schemes. In a principal-agent model in which the effort of a manager with mean-variance preferences affects the mean of a performance measure, we find that managerial compensation must be such that the variance of payments is decreasing in effort. From an ex-ante perspective, which is relevant for effort inducement, this maximizes the rewards associated to high effort, and the punishments associated to low effort. An important practical implication is that convex incentive contracts do not satisfy this necessary condition for optimality, which calls into question the practice of granting executive stock options. The paper therefore contributes to the debate on the efficiency of executive compensation

Explaining the structure of CEO incentive pay with decreasing relative risk aversion

It is established that the standard principal-agent model cannot explain the structure of commonly used CEO compensation contracts if CRRA preferences are postulated. However, we demonstrate that this model has potentially a high explanatory power with preferences with decreasing relative risk aversion, in the sense that a typical CEO contract is approximately optimal for plausible preference parameters

Aversion to the variability of pay and optimal incentive contracts

In a moral hazard setting with a performance additive in effort and a symmetrically distributed noise term, I show that compensation contracts which are convex in performance are suboptimal when the agent has mean-variance preferences. With step contracts, I show that sticks are more efficient than carrots: an exogenously given lower bound on payments is binding at the optimum. Intuitively, the variance of the agent's pay conditional on a high effort should be as low as possible, while it should be as high as possible conditional on a low effort. From an ex ante perspective, which is relevant for effort inducement, this maximizes the rewards associated to high effort, and the punishments associated to low effort. These results call into question the widespread use of stock-options and contracts with rewards-like features to provide incentives to risk averse executives

The effect of risk preferences on the valuation and incentives of compensation contracts

We use a comparative approach to study the incentives provided by different types of compensation contracts, and their valuation by risk averse managers, in a fairly general setting. We show that concave contracts tend to provide more incentives to risk averse managers, while convex contracts tend to be more valued by prudent managers. Thus, prudence can contribute to explain the prevalence of stock-options in executive compensation. We also present a condition on the utility function which enables to compare the structure of optimal contracts associated with different risk preferences

Downside risk neutral probabilities

Risk neutral probabilities are adjusted to take into account the asset price effect of risk preferences. This paper introduces downside (respectively outer) risk neutral probabilities, which are adjusted to take into account the asset price effect of preferences for downside (resp. outer) risk and higher degree risks. Using risk preference theory, we interpret these three changes in probability measures in terms of risk substitution. With downside risk neutral probabilities, the pricing kernel is linear in wealth. Outer risk neutral probabilities can be viewed as a reasonable approximation of physical probabilities

The structure of CEO pay: pay-for-luck and stock-options

We develop a stylized model of efficient contracting in which firms compete for CEOs. The optimal contracts are designed to retain and insure CEOs. The retention motive explains pay-for-luck in executive compensation, while the insurance feature explains asymmetric pay-for-luck. We show that the optimal contract can be implemented with stockoptions based on a single performance measure which does not filter out luck. When the capacity to dismiss underperforming CEOs differs across firms, and the ability of different CEOs is more or less precisely estimated ex-ante, endogenous matching between CEOs and firms can explain the observed association between pay-for-luck and bad corporate governance. The model also predicts that an improvement in the governance of badly governed firms has spillover effects that increase CEO pay in all firms

Essays on CEO compensation.

This thesis analyzes CEO compensation contracts in a principal-agent framework with moral hazard. It focuses on two issues: the form and the timing of performance-based pay. On the one hand, if CEOs are assumed to be mean-variance maximizers, I show that it is suboptimal to provide incentives with contracts which are convex in performance. This is because these contracts make the variance of pay an increasing function of the CEO's effort, which is inefficient. Sticks are more efficient than carrots, although the latter may be used in case the agent is protected by limited liability. On the other hand, if CEOs are assumed to be not only risk averse but also prudent, convex contracts and rewards may be optimal, since they protect against downside risk. A calibration of a HARA-lognormal model shows that CEO preferences which minimize the suboptimality of the typically observed contracts (relative to the optimal contract) feature decreasing absolute risk aversion, as well as low and decreasing relative risk aversion. However, when CEO pay is contingent on a lognormally distributed stock price, it is hard to rationalize the use of convex contracts for incentive provision. The thesis then examines the optimal evaluation and payment date, when the CEO's actions materialize with a lag. Information asymmetries are progressively resolved: the precision of signals that shareholders receive regarding the final outcome is increasing with time. However, the accumulation of exogenous shocks make deferred compensation noisy. The optimal timing of CEO pay, which minimizes the extent of the mispricing at the payment date, is derived. Opportunities for two types of managerial short-termism are then introduced. To ensure that the manager does not engage in short-termist and inefficient behavior, it is often optimal to reduce the power of incentives, and to postpone the evaluation and payment date

Does improved information improve incentives?

This paper studies the value of more precise signals on agent performance in an optimal contracting model with endogenous effort. With limited liability, the agent's wage is increasing in output only if output exceeds a threshold, else it is zero regardless of output. If the threshold is sufficiently high, the agent only beats it, and is rewarded for increasing output through greater effort, if there is a high noise realization. Thus, a fall in output volatility reduces effort incentives—information and effort are substitutes—offsetting the standard effect that improved information lowers the cost of compensation. We derive conditions relating the incentive effect to the underlying parameters of the agency problem

Transparency in the financial system: rollover risk and crises

The paper presents a theory of optimal transparency in the financial system when financial institutions have short-term liabilities and are exposed to rollover risk. Our analysis indicates that transparency enhances the stability of the financial system during crises but may have a destabilizing effect during normal economic times. Thus, the optimal level of transparency is contingent on the state of the economy, with the regulator increasing disclosure in times of crises. Under this policy, however, an increase in disclosure signals a deterioration of the economy's fundamentals, so the regulator has incentives to withhold information ex-post. In that case, the regulator may have to commit ex-ante to a degree of transparency which trades off the frequency and magnitude of financial crises. The analysis also considers the possibility that financial institutions, in an attempt to deal with rollover risk, either diversify their risks or increase the liquidity of their balance sheets