RFS Advance Access published online on April 22, 2008
Review of Financial Studies, doi:10.1093/rfs/hhn037
Optimal Executive Compensation when Firm Size Follows Geometric Brownian Motion
Kellogg School of Management, Northwestern University
Address correspondence to Zhiguo He, Finance Department, Kellogg School of Management, Northwestern University, 2001 Sheridan Road, Evanston, IL 60208; telephone: (847) 491-8348; fax: 847-491-5719; e-mail: he-zhiguo{at}kellogg.northwestern.edu
JEL Classification: G32, D82, E2
 |
Abstract |
|---|
This paper studies a continuous-time agency model in which the agent controls the drift of the geometric Brownian motion firm size. The changing firm size generates partial incentives, analogous to awarding the agent equity shares according to her continuation payoff. When the agent is as patient as investors, performance-based stock grants implement the optimal contract. Our model generates a leverage effect on the equity returns, and implies that the agency problem is more severe for smaller firms. That the empirical evidence shows that grants compensation are largely based on the CEO's historical performance—rather than current performance—lends support to our model.
I thank Mike Fishman, my adviser, for numerous suggestions and endless encouragement, and am grateful to an anonymous referee and Yacine Ait-Sahalia (the Editor) for valuable comments. I benefit from discussions with Peter DeMarzo, Joey Engelberg, Arvind Krishnamurthy, Bob McDonald, Vadim di Pietro, Yuliy Sannikov, and Costis Skiadas. I am indebted to Joey Engelberg for his contribution to the empirical work. All errors are mine.