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Market based compensation, price informativeness and short-term trading

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  • Calcagno, Riccardo
  • Heider, Florian

Abstract

This paper shows that there is a natural trade-off when designing market based executive compensation. The benefit of market based pay is that the stock price aggregates speculators' dispersed information and there-fore takes a picture of managerial performance before the long-term value of a firm materializes. The cost is that informed speculators' willingness to trade depends on trading that is unrelated to any information about the firm. Ideally, the CEO should be shielded from shocks that are not informative about his actions. But since information trading is impossible without non- nformation trading (due to the "no-trade" theorem), shocks to prices caused by the latter are an unavoidable cost of market based pay. This trade-off generates a number of insights about the impact of market conditions, e.g. liquidity and trading horizons, on optimal market based pay. A more liquid market leads to more market based pay while short-term trading makes it more costly to provide such incentives leading to lower CEO effort and worse firm performance on average. The model is consistent with recent evidence showing that market based CEO incentives vary with market conditions, e.g. bid-ask spreads, the probability of informed trading (PIN) or the dispersion of analysts' forecasts. JEL Classification: G39, D86, D82

Suggested Citation

  • Calcagno, Riccardo & Heider, Florian, 2007. "Market based compensation, price informativeness and short-term trading," Working Paper Series 735, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2007735
    Note: 276127
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    File URL: https://www.ecb.europa.eu//pub/pdf/scpwps/ecbwp735.pdf
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    References listed on IDEAS

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    Cited by:

    1. Małgorzata Janicka & Aleksandra Pieloch-Babiarz & Artur Sajnóg, 2020. "Does Short-Termism Influence the Market Value of Companies? Evidence from EU Countries," JRFM, MDPI, vol. 13(11), pages 1-22, November.
    2. Manganelli, Simone & Wolswijk, Guido, 2007. "Market discipline, financial integration and fiscal rules: what drives spreads in the euro area government bond market?," Working Paper Series 745, European Central Bank.
    3. Jalava, Jukka & Kavonius, Ilja Kristian, 2007. "Durable goods and their effect on household saving ratios in the euro area," Working Paper Series 755, European Central Bank.

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    More about this item

    Keywords

    Executive compensation; liquidity; moral hazard; stock price informativeness.; trading;
    All these keywords.

    JEL classification:

    • G39 - Financial Economics - - Corporate Finance and Governance - - - Other
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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