Abstract
We study the role of stock market characteristics on managerial compensation. A risk averse manager exerts an unobservable effort that drives future firm value. The value cannot be used in the incentive contract because it realizes in the distant future and compensating the manager cannot be postponed until then. Instead, the contract uses the stock price as well as public information about the future value of the firm. The stock price emerges endogenously because of trading by informed and uninformed traders in a standard competitive noisy rational expectations equilibrium model. It is well known that liquidity facilitates trading on private information. We identify a dark side of liquidity for incentive contracting. More liquidity makes the stock price less responsive to trading and hence, less sensitive to the manager's effort. Our model yields novel comparative statics, e.g., the manager may receive more stock-based pay when traders' information becomes worse. The contract always uses public information except in the special case when uninformed traders are risk-neutral.
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