The Executive Compensation Puzzle: Theory and Evidence

43 Pages Posted: 20 Jun 1998

See all articles by Todd T. Milbourn

Todd T. Milbourn

Washington University in Saint Louis - Olin Business School

Date Written: November 1997

Abstract

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

Milbourn, Todd T., The Executive Compensation Puzzle: Theory and Evidence (November 1997). Available at SSRN: https://ssrn.com/abstract=99728 or http://dx.doi.org/10.2139/ssrn.99728

Todd T. Milbourn (Contact Author)

Washington University in Saint Louis - Olin Business School ( email )

1 Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6392 (Phone)
314-935-6359 (Fax)

HOME PAGE: http://www.olin.wustl.edu/faculty/milbourn/

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
921
Abstract Views
3,484
rank
35,632
PlumX Metrics