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Optimal CEO Compensation and Option Repricing

Arantxa Jarque

No 881, 2007 Meeting Papers from Society for Economic Dynamics

Abstract: We study the incentive problem between the owners of a firm and its CEO due to the unobservability of the manager's actions. Our model departs from the literature in two ways. First, we assume the effort of the CEO is persistent: his actions affect the performance of the firm for several periods. Second, we derive the effect of effort on stock prices from primitives; i.e., effort affects directly the conditional distribution of profits, and not the distribution of prices. We assume the quality of the firm is uncertain to managers, owners and stock buyers. The stock market determines the price of the stock using information about past profits to learn about the quality of the firm. A complete characterization of the optimal compensation contract for the CEO, assuming unlimited compensation instruments, is given as a benchmark. The optimal compensation can be a convex, concave or even non--monotonic function of profit. Typically, it implies different sensitivity of compensation to profits for different levels of profits. We study the implementation of the optimal contract with a stylized compensation scheme including a salary, a bonus program, stock options and restricted stock grants. We show how the number of options in the grant and especially the exercise price are used to best exploit the correlation between stock prices and likelihood ratios of profits. The learning process about the quality of the firm determines the stock price for each history of profit realizations: it implies a certain sensitivity of stock prices to profits. As opposed to simple restricted stock grants, which imply constant sensitivity of compensation to prices, option grants provide greater flexibility: using them allows us to transform the market--given sensitivity of prices into the sensitivity of compensation in the optimal contract. We describe the conditions under which the optimal wage scheme is non--monotonic with respect to output: when the effort of the CEO is not very effective in inducing high profits if the quality of the firm is bad, a repeated stream of low profits that bring the stock price down may become a better signal of high effort than a series of mixed results. In this context, committing to repricing options that have gone out--of--the--money is the cheapest way to provide incentives. We argue that this is consistent with the empirical evidence (Brenner et al. (2000), Chance et al., 2000): repricing occurs after periods of continued poor firm--specific performance, and it is more common among small firms.

Date: 2007
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More papers in 2007 Meeting Papers from Society for Economic Dynamics Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA. Contact information at EDIRC.
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