DP6890 Executive Compensation and Stock Options: An Inconvenient Truth

Author(s): Jean-Pierre Danthine, John B Donaldson
Publication Date: June 2008
Keyword(s): business cycles, convex contracts, corporate governance, executive compensation, optimal contracting, stock options
JEL(s): E32, E44
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6890

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.