Executive Pay-for-Performance Sensitivity and Stochastic Volatility

45 Pages Posted: 4 Aug 2022

See all articles by Shuaiyu Chen

Shuaiyu Chen

Purdue University - Krannert School of Management

Ping Liu

Krannert School of Management, Purdue University

Yan Liu

Purdue University

Date Written: July 29, 2022

Abstract

This paper studies, both theoretically and empirically, the optimal executive compensation when firm performance is a noisy signal of executive’s hidden effort and the volatility of firm performance is stochastic. We build a tractable dynamic principal-agent model and show analytically that pay-for-performance sensitivity (PPS) decreases in both short-run and long-run components of volatility, but the mechanisms are different:1) the short-run volatility directly affects the effort level implemented by the optimal contract, and 2) the long-run volatility affects PPS through its impact on firm value sensitivity to the short-run volatility. Using the short-run and long-run volatilities estimated from stock option data, we find evidence supporting the model’s implications: while both short-run and long-run volatilities are negatively correlated with PPS, firm operating performance, a direct outcome of executive effort in our model, ONLY decreases with the short-run volatility. Our paper highlights the importance, as well as the intricacies, of stochastic volatility in executive
compensation design.

Keywords: Executive compensation, Stochastic volatility, Pay-for-performance sensitivity, Principal-agent problem

JEL Classification: D86, G12, G34

Suggested Citation

Chen, Shuaiyu and Liu, Ping and Liu, Yan, Executive Pay-for-Performance Sensitivity and Stochastic Volatility (July 29, 2022). Available at SSRN: https://ssrn.com/abstract=4175838 or http://dx.doi.org/10.2139/ssrn.4175838

Shuaiyu Chen

Purdue University - Krannert School of Management ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States
5853198838 (Phone)
47906-1744 (Fax)

Ping Liu

Krannert School of Management, Purdue University ( email )

1310 Krannert Building
West Lafayette, IN 47907-1310
United States
7654944691 (Phone)

Yan Liu (Contact Author)

Purdue University ( email )

West Lafayette, IN 47907-1310
United States

HOME PAGE: http://yliu1.com

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