The overall objective of this project is to develop and to test a model which can explain the observed structure of management-compensation contracts. So far, a static version of the principal-agent model has been the standard choice in the literature. However, previous research shows that in particular the widespread use of stock options cannot be explained by this model. In such a model options, which are high-risk, are an inefficient form of compensation. A new test demonstrates this clearly by numerically identifying the optimal contracts for individual CEOs and comparing them to the respective observed contracts. This method also examines the quantitative implications of the model and is therefore able to distinguish between models with similar qualitative predictions. As part of this project we will redesign existing models or formulate new will that can be parameterized and calibrated in order to use the same method.
As an alternative to the standard model, we will consider and test several extensions (explicit modeling of the manager’s investment strategy, alternative preference models, dynamic utility functions). We will particularly try to substantiate the hypothesis that compensation contracts not only create incentives, but also regulate the risk of future renegotiations of these contracts. Furthermore, in a later phase of this project, we will test the models developed in project A4 empirically. The database to be used will be built from Compustat ExecuComp in cooperation with the FEDC.