Executive Compensation, Incentives, and Risk
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4466-02.pdf
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Author(s)
Jenter, Dirk
Date Issued
December 10, 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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