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Executive Compensation, Incentives, and Risk

Dirk Jenter ()

No 4466-02, Working papers from Massachusetts Institute of Technology (MIT), Sloan School of Management

Abstract: This paper analyzes the link between equity-based compensation and created incentives by (1) deriving a measure of incentives suitable for both linear and non-linear compensation contracts, (2) analyzing the effect of risk on incentives, and (3) clarifying the role of the agent's private trading decisions in incentive creation. With option-based compensation contracts, the average pay-forperformance sensitivity is not an adequate measure of ex-ante incentives. Pay-for-performance covaries negatively with marginal utility and hence overstates the created incentives. Second, more noise in the performance measure implies that the manager is less certain about the effect of effort on performance, which in turn makes her less willing to exert effort. Finally, the private trading decisions by the manager have first-order effects on incentives. By reducing her holdings of the market asset, the manager achieves an effect similar to "indexing" the stock or option grant, making explicit indexation of the contract redundant.

Keywords: executive compensation; equity-based compensation; created incentives (search for similar items in EconPapers)
Date: 2004-12-10
New Economics Papers: this item is included in nep-bec and nep-cfn
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