Noise Pollution: Why Optimal Contracts Expose Managers to Short-Term Market Movements

Posted: 7 Sep 1999

See all articles by Gerald T. Garvey

Gerald T. Garvey

Blackrock

Simon Grant

Rice University - Department of Economics; Australian National University

Stephen P. King

Monash University - Department of Economics; Productivity Commission

Date Written: October 1994

Abstract

This paper analyzes the optimal use of short and long-term share prices in management incentive contracts. We assume that the short-term share price is determined even before the manager has made her effort choice and, therefore, cannot be informative in the standard principal-agent sense. We show that when share traders have as much information as the firm does, the short-term share price is used to index the manager's compensation, and she is paid only according to returns over and above the short-term share price. We then allow the manager to have some private information that is relevant to the short-term share price. In this case, full indexation is impossible and the manager's optimal pay will depend not only on long-term "fundamantals" but also on short-term stock prices. This result endogenizes corporate managers' concern with short-term stock market fluctuations.

JEL Classification: D23, G30

Suggested Citation

Garvey, Gerald T. and Grant, Simon Harold and King, Stephen Peter, Noise Pollution: Why Optimal Contracts Expose Managers to Short-Term Market Movements (October 1994 ). Available at SSRN: https://ssrn.com/abstract=5786

Gerald T. Garvey (Contact Author)

Blackrock ( email )

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Simon Harold Grant

Rice University - Department of Economics ( email )

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Australian National University ( email )

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Stephen Peter King

Monash University - Department of Economics ( email )

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Australia

Productivity Commission ( email )

Level 28
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Melbourne, Victoria, Victoria 3000
Australia

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