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Stock-Based Compensation and CEO (Dis)Incentives

  • Efraim Benmelech

    (Harvard University and National Bureau of Economic Research.)

  • Eugene Kandel

    (University of Chicago, Center for Economic and Policy Research, and National Bureau of Economic Research.)

  • Pietro Veronesi

    (Hebrew University and Center for Economic and Policy Research.)

The use of stock-based compensation as a solution to agency problems between shareholders and managers has increased dramatically since the early 1990s. We show that in a dynamic rational expectations model with asymmetric information, stock-based compensation not only induces managers to exert costly effort, but also induces them to conceal bad news about future growth options and to choose suboptimal investment policies to support the pretense. This leads to a severe overvaluation and a subsequent crash in the stock price. Our model produces many predictions that are consistent with the empirical evidence and are relevant to understanding the current crisis. (c) 2010 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology..

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Article provided by MIT Press in its journal Quarterly Journal of Economics.

Volume (Year): 125 (2010)
Issue (Month): 4 (November)
Pages: 1769-1820

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Handle: RePEc:tpr:qjecon:v:125:y:2010:i:4:p:1769-1820
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