Stock Price Based Compensation and Managerial Myopia in a Dynamic Agency Setting

Abstract

I study the impact of stock price informativeness on incentives and contractual efficiency in a dynamic agency setting. In the model, the firm's stock price is the outcome of speculative trading that efficiently impounds dispersed information in the market. The stock price is an aggregate and rational forecast of future firm value, but as a managerial performance measure, it includes incentive irrelevant noise and is insensitive to the actual effort decision of the manager. Under multi-period contracting, the interim stock price also acts as the performance benchmark for the subsequent period. When contracts are renegotiated in light of updated beliefs about future firm value, these two conflicting roles of stock price -- current performance measure and future performance benchmark -- are not optimally coordinated over time. Consequently, there are many situations where stock price informativeness negatively impacts the manager's long-term effort incentive and contractual efficiency. Furthermore, when firm insiders can form their own more accurate forecast of future cash flow, a long-term renegotiable contract contingent only on realized cash flow can outperform a long-term full commitment contract contingent on both interim stock price and realized cash flow.