This paper summarizes the empirical and theoretical research on executive compensation and provides a comprehensive and up-to-date description of pay practices (and trends in pay practices) for chief executive officers (CEOs). Topics discussed include the level and structure of CEO pay (including detailed analyses of annual bonus plans, executive stock options, and option valuation), international pay differences, the pay-setting process, the relation between CEO pay and firm performance (“pay-performance sensitivities”), the relation between sensitivities and subsequent firm performance, relative performance evaluation, executive turnover, and the politics of CEO pay.

We explore behavioral explanations for sub-optimal corporate investment decisions. Focusing on the sensitivity of investment to cash flow, we argue that personal characteristics of chief executive officers, in particular overconfidence, can account for this widespread and persistent investment distortion. Overconfident CEOs overestimate the quality of their investment projects and view external finance as unduly costly. As a result, they invest more when they have internal funds at their disposal. We test the overconfidence hypothesis, using data on personal portfolio and corporate investment decisions of CEOs in Forbes 500 companies. We classify CEOs as overconfident if they repeatedly fail to exercise options that are highly in the money, or if they habitually acquire stock of their own company. The main result is that investment is significantly more responsive to cash flow if the CEO displays overconfidence. In addition, we identify personal characteristics other than overconfidence (education, employment background, cohort, military service, and status in the company) that strongly affect the correlation between investment and cash flow. We are indebted to Brian Hall and David Yermack for providing us with the data. We are very grateful to Jeremy Stein for his invaluable support and comments. We also would like to thank Philippe Aghion, George

Does CEO overconfidence help to explain merger decisions? Overconfident CEOs overestimate their ability to generate returns. As a result, they overpay for target companies and undertake value-destroying mergers. The effects are strongest if they have access to internal financing. We test these predictions using two proxies for overconfidence: CEOs' personal overinvestment in their company and their press portrayal. We find that the odds of making an acquisition are 65 % higher if the CEO is classified as overconfident. The effect is largest if the merger is diversifying and does not require external financing. The market reaction at merger announcement (–90 basis points) is significantly more negative than for non-overconfident CEOs (–12 basis points). We consider alternative interpretations including inside information, signaling, and risk tolerance.

orporate governance is generally considered to be the set of complementary mechanisms that help align the actions and choices of managers with the interests of shareholders. Monitoring actions by the board of directors, debtholders, or

By examining how executive compensation structure determines corporate acquisition decisions, we document a strong positive relation between acquiring managers' equity-based compensation (EBC) and stock price performance around and following acquisition announcements. This relation is highly robust when we control for acquisition mode (mergers), means of payment, managerial ownership, and previous option grants. Compared to low EBC managers, high EBC managers pay lower acquisition premiums, acquire targets with higher growth opportunities, and make acquisitions engendering larger increases in firm risk. EBC significantly explains post-acquisition stock price performance even after controlling for acquisition mode, means of payment, and “glamour ” versus “value ” acquirers.

Incentive options are held by managers and employees who invariably hold undiversified portfolios with substantial amounts invested in their own company’s common stock. This lack of diversification makes the subjective value of incentive items such as options less than their market value. This paper derives a model for the marginal value of such options or other incentive items. As such, it can be used to evaluate heterogeneous options which mature on different dates. It can also be used each time a new option is granted. The identical model (with different parameters) can be used to determine three different values for each option, the market value, the subjective value and the objective values. The market value is the value the option would have if it were held by an unconstrained agent. The subjective value — the value of the holder — is less than the market value because the option is held in an undiversified portfolio and because it is exercised suboptimally from the market perspective. The objective value is the cost to the firm of issuing the option and lies between the market and subjective values. This value recognizes the suboptimal exercise but not the undiversified discount. The model is no more difficult to use than is the Black-Scholes model. In fact, under the same conditions, it is simply the Black-Scholes model with modified parameters. The model can also be easily extended to handle vesting, employment termination, indexing, repricing and any number of other features found in incentive options.

This paper extends the investigation of the effect of managerial motives on hedging policy. I utilize a proxy variable that incorporates CEO incentives to increase risk versus stock price. The variable is directly measured using the characteristics of CEO portfolios of stock and option holdings. Furthermore, CEO risk-taking incentives are modeled as a choice variable to eliminate the simultaneity bias of modeling risk-taking incentives as an exogenous variable. CEO risk-taking incentives are negatively related to net derivative holdings for a large cross-sectional sample of firms. This effect is only weakly apparent in one-stage models of risk management. If modeled as a simultaneous system of equations, a strong negative link between CEO risk-taking incentives and the amount of derivative holdings exists. This result is consistent with the notion that derivatives are used for hedging purposes. Both the characteristics of stock and option holdings are important in determining cross-sectional differences in corporate derivative holdings.

Economics is not only a social science, it is a genuine science. Like the physical sciences, economics uses a methodology that produces refutable implications and tests these implications using solid statistical techniques. In particular, economics stresses three factors that distinguish it from other social sciences. Economists use the construct of rational individuals who engage in maximizing behavior. Economic models adhere strictly to the importance of equilibrium as part of any theory. Finally, a focus on efficiency leads economists to ask questions that other social sciences ignore. These ingredients have allowed economics to invade intellectual territory that was previously deemed to be outside the discipline’s realm. By almost any market test, economics is the premier social science. The �eld attracts the most students, enjoys the attention of policy-makers and journalists, and gains notice, both positive and negative, from other scientists. In large part, the success of economics derives from its rigor and relevance as well as from its

An innovative business practice attributed to the information technology industry is the aggressive use of employee stock options to compensate executives and other employees. The pervasiveness of stock options among high-tech firms in Silicon Valley is often described as a phenomenon unique to the Valley’s culture. In this study, we investigate whether the greater use of stock options in the information technology industry can be explained on the basis of general economic relationships that apply to firms in all industries. Our empirical model is a system of simultaneous equations that captures the interconnectedness between compensation, performance, and specific forms of compensation. We document the impact of the form of compensation on performance and total compensation. Based on previous literature, we also identify economic factors expected to influence the use of stock options and show that there are significant differences between information technology and other industries. While these factors explain much of the greater use of options in the information technology firms, a significant residual difference remains. Considering these factors, we also find that executives in the information technology industry are not compensated at a level higher than those in other industries.

Risk Shifting, and Benefits of Benchmarking in Money Management Money managers are rewarded for increasing the value of assets under management, and predominately so in the mutual fund industry. This compensation scheme gives the manager an implicit incentive to exploit the well-documented positive fund-flows to relative-performance relationship by manipulating her risk exposure. It also provides her with an explicit incentive to manage the fund in accordance with her own appetite for risk. In a dynamic asset allocation framework, we show that as the year-end approaches, the interplay of these incentives induces the manager to optimally closely mimic the index, relative to which her performance is evaluated, when the fund’s year-todate return is just sufficient to cause a higher expected flow. As she falls behind, she gradually increases her risk exposure (via leverage or short selling), reaching an extremum at a critical level of underperformance. This policy results in economically significant deviations from investors ’ desired risk exposure, substantially impairing their welfare. To better align investors ’ and managers’ incentives, investors or regulators can impose a benchmarking restriction on the fund manager,