Liquidity, Information Aggregation, and Market-Based Pay in an Efficient Market

45 Pages Posted: 1 Jun 2016

See all articles by Riccardo Calcagno

Riccardo Calcagno

Politecnico di Torino

Florian Heider

European Central Bank (ECB); Centre for Economic Policy Research (CEPR)

Date Written: May 2016

Abstract

This paper studies the usefulness of making the income of a CEO depend on the stock price of the firm he runs. We assume the stock market is efficient and find that other public information about CEO performance, e.g., accounting information, is not used to determine CEO pay. But because of the feedback loop between CEO actions and the stock price, the price does not fully reflect the consequences of CEO shirking for the value of the firm. The optimal incentive contract increases stock-based pay in order to increase the sensitivity of CEO income to shirking and thus deter it. This effect is stronger when traders have worse information, which can explain the prevalence of stock-based pay in hard-to-value firms. Our model derives a measure of the wedge between financial and economic efficiency, and generates new insights about the role of market conditions such as liquidity for optimal pay contracts.

Keywords: efficient markets, information aggregation, liquidity, market-based pay

JEL Classification: D86, G14, G34

Suggested Citation

Calcagno, Riccardo and Heider, Florian, Liquidity, Information Aggregation, and Market-Based Pay in an Efficient Market (May 2016). CEPR Discussion Paper No. DP11298, Available at SSRN: https://ssrn.com/abstract=2786900

Riccardo Calcagno (Contact Author)

Politecnico di Torino ( email )

Corso Duca degli Abruzzi, 24
Torino, Torino 10129
Italy

Florian Heider

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

HOME PAGE: http://https://sites.google.com/site/florianheider2/

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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