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Optimal Compensation and Pay-Performance Sensitivity in a Continuous-Time Principal-Agent Model

Author

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  • Nengjiu Ju

    (Department of Finance, School of Business and Management, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong; and Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University, 200030 Shanghai, China)

  • Xuhu Wan

    (Department of Information Systems, Business Statistics and Operations Management, School of Business and Management, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong)

Abstract

This paper studies the optimal contract between risk-neutral shareholders and a constant relative risk-aversion manager in a continuous-time model. Several interesting results are obtained. First, the optimal compensation is increasing but concave in output value if the manager is more risk averse than a log-utility manager. Second, when the manager has a log utility, a linear contract is optimal when there is no explicit lower bound on the compensation, and an option contract is optimal when there is an explicit lower bound. Third, optimal effort is stochastic (state dependent). Fourth, consistent with empirical findings and contrary to standard agency theory predictions, the relationship between pay-performance sensitivity and firm performance and that between pay-performance sensitivity and firm risk can be nonmonotonic. This paper was accepted by Wei Xiong, finance.

Suggested Citation

  • Nengjiu Ju & Xuhu Wan, 2012. "Optimal Compensation and Pay-Performance Sensitivity in a Continuous-Time Principal-Agent Model," Management Science, INFORMS, vol. 58(3), pages 641-657, March.
    • Handle: RePEc:inm:ormnsc:v:58:y:2012:i:3:p:641-657
    DOI: 10.1287/mnsc.1110.1417
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    References listed on IDEAS

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    3. Qi Zeng & Hae Won (Henny) Jung, 2014. "Optimal Contract, Ownership Structure and Asset Pricing," 2014 Meeting Papers 911, Society for Economic Dynamics.
    4. Justin Law & Wayne Yu, 2018. "Corporate spinoffs and executive compensation," Frontiers of Business Research in China, Springer, vol. 12(1), pages 1-25, December.
    5. Claus Dierksmeier, 2020. "From Jensen to Jensen: Mechanistic Management Education or Humanistic Management Learning?," Journal of Business Ethics, Springer, vol. 166(1), pages 73-87, September.
    6. Dirk C. Moosmayer & Sandra Waddock & Long Wang & Matthias P. Hühn & Claus Dierksmeier & Christopher Gohl, 2019. "Leaving the Road to Abilene: A Pragmatic Approach to Addressing the Normative Paradox of Responsible Management Education," Journal of Business Ethics, Springer, vol. 157(4), pages 913-932, July.
    7. Dylan Possamai & Nizar Touzi, 2020. "Is there a Golden Parachute in Sannikov's principal-agent problem?," Papers 2007.05529, arXiv.org, revised Oct 2022.

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