Earnings-Based Compensation Contracts Under Asymmetric Information

Abstract:     
We analyze a model with two-dimensional asymmetric information in which the employer has better information about the firm's earnings potential and the employee is subject to moral hazard. The employee's contract consists of an annual bonus and stock options. We focus on two issues: how different degrees of asymmetric information about short-term earnings versus long-term earnings affect optimal contracts and second, if a signalling equilibrium exists, what information concerning the firm's performance profile over time can be conveyed by the choice of contract. We show that if the extent of long-term (short-term) asymmetric information is larger, short-term (long-term) compensation prevails. With regard to signalling, we show that firms offering more options have higher short-term performance and lower long-term performance. This provides new insights into the structure of earnings-based compensation.

Keywords: Optimal compensation, Asymmetric information, Annual bonus, Stock options

JEL Classification: D82, J33, M12, M52

Accepted Paper Series