DP6890 Executive Compensation and Stock Options: An Inconvenient Truth - CEPR - June 2008

www.cepr.org/pubs/dps/DP6890.asp

We
reexamine the issue of executive compensation within a general
equilibrium production context. Intertemporal optimality places strong
restrictions on the form of a representative manager's compensation
contract, restrictions that appear to be incompatible with the fact
that the bulk of many high-profile managers' compensation is in the
form of various options and option-like rewards. We therefore measure
the extent to which a convex contract alone can induce the manager to
adopt near-optimal investment and hiring decisions. To ask this
question is essentially to ask if such contracts can effectively align
the stochastic discount factor of the manager with that of the
shareholder-workers. We detail exact circumstances under which this
alignment is possible and when it is not.