On the Design of CEO Compensation Contracts

Abstract

The empirical literature testing hypotheses on the casual relation between the CEO compensation policies and other factors mainly relies on the predictions by the classical principal-agent theory, which are mostly descriptive and vague. In this paper we develop a theory of optimal CEO compensation design in continuous-time that incorporates several important factors of practical relevance into analysis. Our model is tractable and has a closed-form nonlinear solution. It provides a uni ed framework that links the CEO compensation schemes to three dimensions that are perceived to be mostly relevant in practice: 1) the rm's accounting return; 2) the rm's stock return and 3) relative performance measures such as market indexes. We show that the design of the optimal CEO compensation can be decomposed into two steps. First, an aggregate performance index (API), which is a certain linear combination of the three signals, is constructed. Second, the optimal compensation is shown to be a nonlinear function of the API. Testable implications are derived and their relevance to empirical literature is discussed in details.