Executive Compensation and Stock Options: An Inconvenient Truth

The objective of this paper is to propose a number of alternative decentralized interpretations of representative agent style stochastic growth economies and to explore their implications for the generality of this model construct. August 27, — The Wall Street Journal. What Is Corporate Governance? CEO compensation , stock options. The Center believes options have a place in a well-balanced compensation design, especially to demonstrate alignment with shareholders over the long term.

Executive Compensation and Stock Options: An Inconvenient Truth In this paper we reexamine executive compensation within a general equilibrium intertemporal production context. We flrst observe that in-tertemporal optimality places strong restrictions on the form of a represen-.

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Stock options increasingly dominate CEO pay packages. The answer is that boards of directors are likely giving too many executive stock options. Occasionally this practice has led to aggregate compensation payments that are so large as to mock the very connection they are supposed to encourage. What does economic theory have to say about executive compensation in a dynamic context? From a conceptual perspective, how effective is the granting of stock options in promoting the correct managerial decisions?

When the systemic implications of executive remuneration are taken into account, that is, in a general equilibrium context, one finds that for a contract to induce managers to take the correct business decisions in the above sense, it must naturally have the following three features.

This concurs with the general message of a wealth of microeconomics studies. But this is not sufficient. This later restriction arises because, as is well known, the income and consumption position of a manager will determine his or her willingness to undertake risky projects. This asymmetry is necessary induce risk averse managers to make the right investment decisions from the perspective of well-diversified stockholders. Shareholders receive both wage and dividend income, with the wage or salary component being, on average, the larger of the two.

This is an implication of National Income Accounting. Points 1 and 2 above therefore imply that an optimal contract will have both a salary with properties close to those of the wage bill and an incentive component with properties naturally linked to the income accruing to capital owners with the former being about twice as large as the latter.

They typically prefer a highly pro-cyclical investment policy whereas, without further inducement, the manager will be much more reluctant to exploit the good opportunities and instead select a mildly pro-cyclical or, even, possibly an anti-cyclical investment strategy. This problem is well recognised, and it is the main justification for using highly convex managerial compensation contracts i. That is, even a compensation contract that is heavily laden with options will not induce managers to alter their behaviour one whit.

A straightforward application of this logic produces an even more striking result. This would mean a contract that pays high compensation when profits are low and vice versa.

In this situation an options laden compensation package will induce the manager to behave in a manner directly opposite to what the shareholders would like. More generally, the degree of contract convexity must be related to the relative risk aversion of the manager as compared to the shareholders and if these quantities are not precisely estimated large welfare losses will ensue. From a theoretical macroeconomic perspective, the circumstances under which a highly convex compensation contract, for example, one that has a large component of options, will properly guide the manager in making the correct hiring and investment decisions are very narrowly defined.

Danthine, Jean-Pierre and John B. Enjoying the Quiet Life? Corporate Governance and Managerial Control. Sendhil Mullainathan Marianne Bertrand. Feb J Eur Econ Assoc. Philippe Aghion Jeremy C. Discover more publications, questions and projects in Executive Compensation.

We study the dynamic general equilibrium of an economy where risk averse shareholders delegate the management of the firm to risk averse managers. The optimal contract has two main components: Tying a manager's compensation to The View from General Equilibrium. One interpretation of the RBC research program is that it was meant to identify and incorporate into dynamic general equilibrium models those market imperfections which are most relevant for macroeconomic theory and policy.

This paper reviews the methodological basis for this interpretation. It then discusses the empirical foundations for some of the many frictions that have found their way Decentralizing the Stochastic Growth Model. The objective of this paper is to propose a number of alternative decentralized interpretations of representative agent style stochastic growth economies and to explore their implications for the generality of this model construct. Under our first interpretation, firms exist forever and undertake all multiperiod investment decisions while consumer-worker-investors only own financial claims to

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Request PDF on ResearchGate | Executive Compensation and Stock Options: An Inconvenient Truth | We reexamine the issue of executive compensation within a gen- eral equilibrium production context. Executive Compensation and Stock Options: An Inconvenient Truth. Swiss Finance Institute Research Paper No. 32 Pages Posted: 8 Jul Jean-Pierre Danthine. University of Lausanne - Institute of Banking and Finance (IBF); Centre for Economic Policy Research (CEPR); Swiss Finance Institute. Executive Compensation: Salary vs. Incentive Pay: An Inconvenient Truth* Jean-Pierre Danthine Member of the Governing Board of the Swiss National Bank More significantly, the grant-date value of stock options accounted for 47% of total pay for S&P CEOs in ” For March , Mercer Consulting estimates that equity .