Executive Compensation, Incentives, and Risk
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4466-02.pdf
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373.39 KB
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Adobe PDF
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4ba6bfa2634057c2d43de4a242d50567
Author(s)
Jenter, Dirk
Date Issued
May 28, 2004
Series/Report no.
MIT Sloan School of Management Working Paper;4466-02
Abstract
This paper analyzes the link between equity-based compensation and created incentives by (1) deriving a measure of incentives suitable for both linear and non-linear compensation contracts, (2) analyzing the effect of risk on incentives, and (3) clarifying the role of the agent's private trading decisions in incentive creation. With option-based compensation contracts, the average pay-forperformance sensitivity is not an adequate measure of ex-ante incentives. Pay-for-performance covaries negatively with marginal utility and hence overstates the created incentives. Second, more noise in the performance measure implies that the manager is less certain about the effect of effort on performance, which in turn makes her less willing to exert effort. Finally, the private trading decisions by the manager have first-order effects on incentives. By reducing her holdings of the market asset, the manager achieves an effect similar to "indexing" the stock or option grant, making explicit indexation of the contract redundant.
Subjects
executive compensation
equity-based compensation
created incentives
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