DP15755 How Should Performance Signals Affect Contracts?

Author(s): Pierre Chaigneau, Alex Edmans, Daniel Gottlieb
Publication Date: February 2021
Keyword(s): Informativeness principle, limited liability, option repricing, Pay-for-luck, performance-based vesting, performance-sensitive debt
JEL(s): D86, G32, G34, J33
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=15755

The informativeness principle demonstrates that a contract should depend on informative signals. This paper studies how it should do so. Signals that indicate the output distribution has shifted to the left (e.g. weak industry performance) reduce the threshold for the manager to be paid; those that indicate output is a precise measure of effort (e.g. low volatility) decrease high thresholds and increase low thresholds. Surprisingly, "good" signals of performance need not reduce the threshold. Applying our model to performance-based vesting, we show that performance measures should affect the strike price rather than the number of vesting options, contrary to practice.