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Optimal CEO Compensation with Search: Theory and Empirical Evidence
Author(s) -
CAO MELANIE,
WANG RONG
Publication year - 2013
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12069
Subject(s) - executive compensation , principal–agent problem , systematic risk , microeconomics , compensation (psychology) , economics , externality , agency (philosophy) , empirical evidence , sensitivity (control systems) , shock (circulatory) , agency cost , business , econometrics , finance , incentive , corporate governance , medicine , psychology , philosophy , epistemology , electronic engineering , psychoanalysis , engineering , shareholder
We integrate an agency problem into search theory to study executive compensation in a market equilibrium. A CEO can choose to stay or quit and search after privately observing an idiosyncratic shock to the firm. The market equilibrium endogenizes CEOs’ and firms’ outside options and captures contracting externalities. We show that the optimal pay‐to‐performance ratio is less than one even when the CEO is risk neutral. Moreover, the equilibrium pay‐to‐performance sensitivity depends positively on a firm's idiosyncratic risk and negatively on the systematic risk. Our empirical tests using executive compensation data confirm these results.