Abstract
We study an optimal contracting problem between shareholders and managers when managers’ effort choices are hidden but on which stock market prices reveal some information. When the stock market rewards winners and punishes losers within an industry, stock-based incentive generates a tournament effect and causes strategic complementarity among managers of different firms in exerting effort. In the presence of this complementarity in managerial efforts, shareholders fail to internalize the impact of incentive provision to their own manager on the average industry effort level. They over (under) incentivise managers, leading managers to exert too much (little) effort, exposing shareholders to excessive (insufficient) systematic risk relative to the second best (and even the first best) during the boom (bust).
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