Market-Based Compensation, Price Informativeness and Short-Term Trading

Abstract

This paper shows that there is a natural trade-off when designing market based executive compensation. The benefit of market based pay is that the stock price aggregates speculators’ dispersed information and there-fore takes a picture of managerial performance before the long-term value of a firm materializes. The cost is that informed speculators’ willingness to trade depends on trading that is unrelated to any information about the firm. Ideally, the CEO should be shielded from shocks that are not informative about his actions. But since information trading is impossible without non- nformation trading (due to the ”no-trade” theorem), shocks to prices caused by the latter are an unavoidable cost of market based pay. This trade-off generates a number of insights about the impact of market conditions, e.g. liquidity and trading horizons, on optimal market based pay. A more liquid market leads to more market based pay while short-term trading makes it more costly to provide such incentives leading to lower CEO effort and worse firm performance on average. The model is consistent with recent evidence showing that market based CEO incentives vary with market conditions, e.g. bid-ask spreads, the probability of informed trading (PIN) or the dispersion of analysts’ forecasts. JEL Classification: G39, D86, D82