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CEO Incentives and Institutional Trader Monitoring are Substitutes: Theory and Evidence

64 Pages Posted: 25 Jan 2010 Last revised: 3 Jan 2012

Brandon Chen

Victoria University of Wellington

Peter L. Swan

University of New South Wales (UNSW Australia); Financial Research Network (FIRN)

Date Written: October 28, 2011

Abstract

The traditional view on CEO pay suggests that the use of equity-based incentives (e.g., stocks and options) should increase when stock prices become more informative about managerial action. In this paper, we show this is only true in the relative sense, when comparing with CEOs’ non-equity-based incentives (e.g., bonus). We confirm our model’s prediction to show that the use of equity-based incentives actually falls when institutional traders impound more information in stock prices. In other words, these two mechanisms are substitutes. These predictions are crystallized by our empirical results, focusing on S&P 1,500 firms from 1992-2007. Despite the lower use of equity-based incentives and the even lower still use of bonus incentives, the CEO works harder and her total compensation increases, as suggested by our model. Our paper not only helps clarify the theoretical agency relation between CEO incentives and price efficiency due to informed trading, but also utilizes a new way to infer price informativeness from the number of institutional informed traders as well as the magnitude of their trades from a “swing” measure of informed trading. In its first application to the United States, we show that the swing measure can be inferred from SEC 13f filings and is robust to a number of tests.

Keywords: Informativeness, Incentives, Substitutes, CEO pay, Institutional monitoring, Governance through Trading

JEL Classification: D82, G14, G23, G32

Suggested Citation

Chen, Brandon and Swan, Peter L., CEO Incentives and Institutional Trader Monitoring are Substitutes: Theory and Evidence (October 28, 2011). AFA 2012 Chicago Meetings Paper; 24th Australasian Finance and Banking Conference 2011 Paper. Available at SSRN: https://ssrn.com/abstract=1542286 or http://dx.doi.org/10.2139/ssrn.1542286

Brandon Chen

Victoria University of Wellington ( email )

School of Economics and Finance
PO Box 600
Wellington, 6140
New Zealand

Peter Lawrence Swan (Contact Author)

University of New South Wales (UNSW Australia) ( email )

School of Banking and Finance
UNSW Business School
Sydney NSW, NSW 2052
Australia
+61 2 9385 5871 (Phone)
+61 2 9385 6347 (Fax)

HOME PAGE: http://https://www.business.unsw.edu.au/our-people/peterswan

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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