Dynamic Compensation under Uncertainty Shocks and Limited Commitment
AFA 2015 Boston Meetings Paper
40 Pages Posted: 22 Aug 2013 Last revised: 22 Jan 2017
Date Written: January 20, 2017
This paper studies optimal dynamic compensation when firms are subject to uncertainty shocks but have only limited ability to commit to long-term contracts. I analyze a continuous-time dynamic principal-agent model with private effort and regime switching in cash flow volatility and characterize the optimal managerial compensation and termination policy. In high volatility times, firms are forced to expedite payments to managers because sufficient deferred compensation is no longer credible. At the same time, contract length shortens, that is, termination becomes more likely. This relation between the timing of payments and expected contract length may explain the sizeable cash bonuses observed in crises times. In contrast, with full commitment firms defer compensation more when volatility is high.
Keywords: dynamic compensation, limited commitment, volatility shock
JEL Classification: D82, D86, G34, M12
Suggested Citation: Suggested Citation