Contracting with Feedback

Abstract

We study the effect of financial market conditions on managerial compensation structure. First, we analyze the optimal pay-for-performance in a model in which corporate decisions and firm value are both endogenous to trading due to feedback from information contained in stock prices. In a less frictional financial market, the improved information content of stock prices helps guide managerial decisions, and this information substitutes out part of the direct incentive provision from compensation contracts. Thus, the optimal pay-for-performance is lowered in response to reductions in market frictions. Second, we test our theory using two quasi-natural experiments and find evidence that is consistent with the theory. Our results indicate that the financial market environment plays an important role in shaping CEO compensation structure.