Optimal CEO Compensation with Search: Theory and Empirical Evidence

• Main Authors: CAO, Melanie, WANG, Rong
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2013
• Subjects: executive compensation; agency problem; chief executive officers; market equilibrium; Corporate Finance; Human Resources Management
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/3238; https://ink.library.smu.edu.sg/context/lkcsb_research/article/4237/viewcontent/WangRong2013Mayjffinal_ceo.pdf
• Institution: Singapore Management University

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.