Information-Based Stock Trading, Executive Incentives, and the Principal-Agent Problem
Florida International University (FIU) - Department of Finance
University of Hong Kong - School of Economics and Finance; Peking University - Guang Hua School of Management
November 1, 2009
Management Science, Forthcoming
We examine the role of information-based stock trading in affecting the risk-incentive relation. By incorporating an endogenous informed trading into an optimal incentive contracting model, we analytically show that, apart from reducing incentives, a greater risk increases the level of information-based trading which consequently enhances executive incentives and offsets the negative risk-incentive relation. We calibrate the model and find that the economic magnitude of this incentive-enhancement effect is significant. Our empirical test using real-world executive compensation data lends strong support to the model prediction. Our results suggest that principals (boards of directors) should consider underlying stock trading characteristics when structuring executive incentives.
Number of Pages in PDF File: 36
Keywords: Risk-incentive tradeoff, endogenous information-based trading, pay-performance sensitivity, adjusted PIN, calibration
JEL Classification: D80, G14, G30, J33Accepted Paper Series
Date posted: March 15, 2006 ; Last revised: March 10, 2010
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