Lower Salaries and No Options: The Optimal Structure of Executive Pay
AbstractWe estimate a standard principal agent model with constant relative risk aversion and lognormal stock prices for a sample of 598 US CEOs. The model is widely used in the compensation literature, but it predicts that almost all of the CEOs in our sample should hold no stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies. For a typical value of relative risk aversion, almost half of the CEOs in our sample would be required to purchase additional stock in their companies from their private savings. The model predicts contracts that would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We investigate a number of extensions and modi.cations of the standard model, but .nd none of them to be satisfactory. We conclude that the standard principal agent model typically used in the literature cannot rationalize observed contracts. One reason may be that executive pay contracts are suboptimal.
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Bibliographic InfoPaper provided by Sonderforschungsbereich 504, Universität Mannheim & Sonderforschungsbereich 504, University of Mannheim in its series Sonderforschungsbereich 504 Publications with number 07-41.
Length: 50 pages
Date of creation: 26 Jun 2007
Date of revision:
Note: Financial support from the Deutsche Forschungsgemeinschaft, SFB 504, at the University of Mannheim, is gratefully acknowledged.
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This paper has been announced in the following NEP Reports:
- NEP-ALL-2008-04-04 (All new papers)
- NEP-BEC-2008-04-04 (Business Economics)
- NEP-CTA-2008-04-04 (Contract Theory & Applications)
- NEP-LAB-2008-04-04 (Labour Economics)
- NEP-UPT-2008-04-04 (Utility Models & Prospect Theory)
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