Optimal CEO Compensation with Search: Theory and Empirical Evidence

71 Pages Posted: 9 Mar 2009 Last revised: 14 Nov 2013

See all articles by Melanie Cao

Melanie Cao

York University - Schulich School of Business

Rong Wang

Singapore Management University; Singapore Management University - Lee Kong Chian School of Business

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Date Written: Nov 20, 2012

Abstract

We integrate an agency problem into search theory to study executive compensation in a market equilibrium. A CEO can choose to stay or quit and search after privately observing an idiosyncratic shock to the firm. The market equilibrium endogenizes CEOs’ and firms’ outside options and captures contracting externalities. We show that the optimal pay-to-performance ratio is less than one even when the CEO is risk neutral. Moreover, the equilibrium pay-toperformance sensitivity depends positively on a firm’s idiosyncratic risk, and negatively on the systematic risk. Our empirical tests using executive compensation data confirm these results.

Keywords: executive compensation, principal-agent problem, search, endogenous outside options, dynamic market equilibrium

JEL Classification: J33, G13

Suggested Citation

Cao, Melanie and Wang, Rong, Optimal CEO Compensation with Search: Theory and Empirical Evidence (Nov 20, 2012). Journal of Finance, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1355502 or http://dx.doi.org/10.2139/ssrn.1355502

Melanie Cao

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100 ext. 33801 (Phone)

Rong Wang (Contact Author)

Singapore Management University ( email )

Li Ka Shing Library
70 Stamford Road
Singapore 178901, 178899
Singapore

Singapore Management University - Lee Kong Chian School of Business ( email )

469 Bukit Timah Road
Singapore 912409
Singapore

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