Sticks or Carrots? Optimal CEO Compensation when Managers are Loss-Averse
46 Pages Posted: 14 Jul 2006 Last revised: 19 Dec 2010
Date Written: March 24, 2008
This paper analyzes optimal executive compensation contracts when managers are loss averse. We calibrate a stylized principal-agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parametrizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and drops discontinuously to the lowest possible payout for low outcomes. We identify the critical features of the loss-aversion model that render optimal contracts convex.
Keywords: Stock Options, Executive Compensation, Loss Aversion
JEL Classification: G30, M52
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