Contracting with Feedback

65 Pages Posted: 28 Aug 2015

See all articles by Tse-Chun Lin

Tse-Chun Lin

The University of Hong Kong - Faculty of Business and Economics

Qi Liu

Peking University - Department of Finance

Bo Sun

University of Virginia Darden School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: August 25, 2015

Abstract

We study the effect of financial market conditions on managerial compensation structure. First, we analyze the optimal pay-for-performance in a model in which corporate decisions and firm value are both endogenous to trading due to feedback from information contained in stock prices. In a less frictional financial market, the improved information content of stock prices helps guide managerial decisions, and this information substitutes out part of the direct incentive provision from compensation contracts. Thus, the optimal pay-for-performance is lowered in response to reductions in market frictions. Second, we test our theory using two quasi-natural experiments and find evidence that is consistent with the theory. Our results indicate that the financial market environment plays an important role in shaping CEO compensation structure.

Keywords: Feedback effect, CEO compensation, Transaction costs, Reg-SHO Pilot program, Decimalization

JEL Classification: G30, J33

Suggested Citation

Lin, Tse-Chun and Liu, Qi and Sun, Bo, Contracting with Feedback (August 25, 2015). FRB International Finance Discussion Paper No. 1143, Available at SSRN: https://ssrn.com/abstract=2650708 or http://dx.doi.org/10.2139/ssrn.2650708

Tse-Chun Lin

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

Qi Liu

Peking University - Department of Finance ( email )

Beijing
China

Bo Sun (Contact Author)

University of Virginia Darden School of Business ( email )

100 Darden Blvd
K, VA 22903
United States
8622453813 (Phone)

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