BibTeX
@MISC{Bertomeu_relativeperformance,
author = {Jeremy Bertomeu},
title = {RELATIVE PERFORMANCE EVALUATION WITH SYSTEMATIC},
year = {}
}
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Abstract
Most observed managerial compensation packages do not filter out systematic economy-wide fluctuations (e.g., market indices, oil prices, macroeconomic variables). However, given that such shocks do not appear informative on individual actions, the limited use of relative performance evaluation (RPE) is unexplained within the conventional model of incentives. Incorporating asset pricing considerations, this paper shows that the cost to a firm of a dollar of compensation is lower after a favorable market-wide shock than after an unfavorable shock. As a result, firms optimally choose a compensation structure in which pay depends on the systematic shock. Further, the systematic shock may be informative on the wealth of the manager, and thus useful to tailor the incentive scheme. Specifically, the optimal contract may imply higher pay-for-performance in good states, because such states feature more personal wealth and thus greater risk tolerance. Under constant relative risk-aversion, a contract with pure RPE is suboptimal even if the manager can privately trade the market. The framework suggests that apparent rejections of RPE may be driven by rational asset pricing effects, and offers an empirical methodology to filter out these effects.
Keyphrases
relative performance evaluation systematic systematic shock incentive scheme personal wealth pure rpe unfavorable shock apparent rejection asset pricing consideration constant relative risk-aversion conventional model empirical methodology risk tolerance compensation structure favorable market-wide shock observed managerial compensation package systematic economy-wide fluctuation limited use oil price relative performance evaluation rational asset pricing effect macroeconomic variable market index individual action optimal contract good state
