The Executive Compensation Puzzle: Theory and Evidence
43 Pages Posted: 20 Jun 1998
Date Written: November 1997
I develop a theory of compensation contracts for the chief executive officers (CEOs) of firms and confront the theoretical predictions with CEO compensation data. My model has the following aspects: a board of directors that behaves strategically in designing the CEO's compensation contract, a financial market in which there are informed investors whose information is noisily incorporated into prices, and a Bayesian belief revision mechanism by which the CEO's past performance impacts his reputation. The theory predicts that the pay-for-performance sensitivity for the CEO is an increasing function of his perceived ability and the liquidity of the financial market.
I then confront these cross-sectional predictions with CEO compensation data for the years 1987 to 1994. Using equity-based proxies for CEO reputation, I document a positive relationship between the pay-for-performance sensitivity and a CEO?s reputation. I also document a positive relationship between the pay-for-performance sensitivity and the measure of informed traders as proxied by the firm?s adverse selection component of the bid-ask spread.
JEL Classification: G30, J33, J44
Suggested Citation: Suggested Citation