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Dynamic Incentive Accounts

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  • Edmans, Alex
  • Gabaix, Xavier
  • Sadzik, Tomasz
  • Sannikov, Yuliy

Abstract

Contracts in a dynamic model must address a number of issues absent from static frameworks. Shocks to firm value may weaken the incentive effects of securities (e.g. cause options to fall out of the money), and the impact of some CEO actions may not be felt until far in the future. We derive the optimal contract in a setting where the CEO can affect firm value through both productive effort and costly manipulation, and may undo the contract by privately saving. The optimal contract takes a surprisingly simple form, and can be implemented by a "Dynamic Incentive Account." The CEO’s expected pay is escrowed into an account, a fraction of which is invested in the firm’s stock and the remainder in cash. The account features state-dependent rebalancing and time-dependent vesting. It is constantly rebalanced so that the equity fraction remains above a certain threshold; this threshold sensitivity is typically increasing over time even in the absence of career concerns. The account vests gradually both during the CEO’s employment and after he quits, to deter short-termist actions before retirement.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7497.

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Date of creation: Oct 2009
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Handle: RePEc:cpr:ceprdp:7497

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Keywords: Contract theory; executive compensation; incentives; manipulation; principal-agent problem; private saving; vesting;

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References

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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. Better incentives for CEOs, and mutual fund managers, too
    by Economic Logician in Economic Logic on 2009-10-14 14:11:00
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Cited by:
  1. Bhagat, Sanjai & Bolton, Brian, 2014. "Financial crisis and bank executive incentive compensation," Journal of Corporate Finance, Elsevier, vol. 25(C), pages 313-341.
  2. Pierre Chaigneau, 2010. "The Optimal Timing of Executive Compensation," FMG Discussion Papers dp660, Financial Markets Group.
  3. George-Marios Angeletos & Alessandro Pavan, 2007. "Socially Optimal Coordination: Characterization and Policy Implications," Journal of the European Economic Association, MIT Press, vol. 5(2-3), pages 585-593, 04-05.
  4. Marco LiCalzi & Alessandro Pavan, 2002. "Tilting the Supply Schedule to Enhance Competition in Uniform- Price Auctions," Game Theory and Information 0210003, EconWPA.
  5. repec:dgr:uvatin:2009076 is not listed on IDEAS
  6. He, Zhiguo, 2011. "A model of dynamic compensation and capital structure," Journal of Financial Economics, Elsevier, vol. 100(2), pages 351-366, May.
  7. Alex Edmans & Xavier Gabaix, 2011. "Tractability in Incentive Contracting," Review of Financial Studies, Society for Financial Studies, vol. 24(9), pages 2865-2894.
  8. Giannetti, Mariassunta, 2011. "Serial CEO incentives and the structure of managerial contracts," Journal of Financial Intermediation, Elsevier, vol. 20(4), pages 633-662, October.
  9. Kim, E. Han & Lu, Yao, 2011. "CEO ownership, external governance, and risk-taking," Journal of Financial Economics, Elsevier, vol. 102(2), pages 272-292.
  10. Daniel Garrett & Alessandro Pavan, 2010. "Managerial Turnover in a Changing World," Discussion Papers 1490, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  11. Alex Gershkov & Motty Perry, 2011. "Dynamic Contracts with Moral Hazard and Adverse Selection," Working Papers 001-11, International School of Economics at TSU, Tbilisi, Republic of Georgia.
  12. Jacek Rothert, 2009. "Monitoring, Moral Hazard and Turnover," Department of Economics Working Papers 130124, The University of Texas at Austin, Department of Economics, revised Sep 2012.

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