Abstract
In this paper, I examine the optimal contracting problem between a firm and its chief executive officer in a principal-agent framework with information asymmetry. The firm (principal) selects the size and composition of the agent's (executive's) compensation in order to maximize firm value. Given a compensation contract, the risk-averse and effort-averse agent in turn maximizes his own expected utility by optimizing his effort at the firm and the allocation of his outside investments. Using parameters consistent with average CEO pay of S&P 500 companies, I find that market performance (stock price) based incentive pay represents an important part (14 to 100%) of the optimal compensation contract between the firm and its executive. However, the optimal contract includes stock option grants only if the executive is at most modestly risk averse (with coefficient of relative risk aversion
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