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Market Based Compensation, Trading And Liquidity

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  • Riccardo Calcagno
  • Florian Heider

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Abstract

This paper examines the role of trading and liquidity in a large competitive market with dispersed heterogenous information on market-based managerial compensation. The paper recognizes the endogenous nature of a firm’s stock price - it is the outcome of self-interested speculative trading motivated by imperfect information about future firm value. Using the stock price as performance measure means bench-marking the manager’s performance against the market’s expectation of that performance. We obtain two main results: first, the degree of market-based compensation is proportional to the market depth, which is a measure of the ease of information trading. Secondly, using the dynamic trading model of Vives (1995) we show that if the investment horizon of informed traders decreases, at equilibrium the managerial e.ort reduces, and the optimal contract prescribes stock-compensation with longer vesting period.

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Bibliographic Info

Paper provided by Universidad Carlos III, Departamento de Economía de la Empresa in its series Business Economics Working Papers with number wb046224.

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Date of creation: Nov 2004
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Handle: RePEc:cte:wbrepe:wb046224

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  1. Ernst Maug, 1998. "Large Shareholders as Monitors: Is There a Trade-Off between Liquidity and Control?," Journal of Finance, American Finance Association, vol. 53(1), pages 65-98, 02.
  2. Rajesh K. Aggarwal & Andrew A. Samwick, 1999. "The Other Side of the Trade-off: The Impact of Risk on Executive Compensation," Journal of Political Economy, University of Chicago Press, vol. 107(1), pages 65-105, February.
  3. Paul, Jonathan M, 1992. "On the Efficiency of Stock-Based Compensation," Review of Financial Studies, Society for Financial Studies, vol. 5(3), pages 471-502.
  4. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-35, November.
  5. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563 Elsevier.
  6. Patrick Bolton & José Scheinkman & Wei Xiong, 2006. "Executive Compensation and Short-Termist Behaviour in Speculative Markets," Review of Economic Studies, Oxford University Press, vol. 73(3), pages 577-610.
  7. Stein, Jeremy C., 1988. "Takeover Threats and Managerial Myopia," Scholarly Articles 3708937, Harvard University Department of Economics.
  8. Vives, X., 1993. "Short-Term Investment and the Informational Efficiency of the Market," UFAE and IAE Working Papers 207.93, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
  9. Lambert, Richard A., 2001. "Contracting theory and accounting," Journal of Accounting and Economics, Elsevier, vol. 32(1-3), pages 3-87, December.
  10. Subrahmanyam, Avanidhar, 1991. "Risk Aversion, Market Liquidity, and Price Efficiency," Review of Financial Studies, Society for Financial Studies, vol. 4(3), pages 416-41.
  11. George P. Baker & Brian J. Hall, 1998. "CEO Incentives and Firm Size," NBER Working Papers 6868, National Bureau of Economic Research, Inc.
  12. Scharfstein, David, 1988. "The Disciplinary Role of Takeovers," Review of Economic Studies, Wiley Blackwell, vol. 55(2), pages 185-99, April.
  13. Diamond, Douglas W. & Verrecchia, Robert E., 1981. "Information aggregation in a noisy rational expectations economy," Journal of Financial Economics, Elsevier, vol. 9(3), pages 221-235, September.
  14. John E. Core & Wayne R. Guay & David F. Larcker, 2003. "Executive equity compensation and incentives: a survey," Economic Policy Review, Federal Reserve Bank of New York, issue Apr, pages 27-50.
  15. Canice Prendergast, 2002. "The Tenuous Trade-off between Risk and Incentives," Journal of Political Economy, University of Chicago Press, vol. 110(5), pages 1071-1102, October.
  16. Jay C. Hartzell & Laura T. Starks, 2003. "Institutional Investors and Executive Compensation," Journal of Finance, American Finance Association, vol. 58(6), pages 2351-2374, December.
  17. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
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