Date of Award
Doctor of Philosophy (PhD)
I study executive compensation in various situations, including the cases where (i) CEOs have relative wealth concerns (RWCs); (ii)inside debt can be a part of an optimal contract; (iii) there are ambiguous information about firm value.
The first chapter, "Relative Wealth Concerns and Executive compensation", studies the implications of RWCs on executive compensation. I first study the case in which a CEO's effort increases firm value without changing firm risk. In this case, RWCs will result in an increase in CEO incentives. This effect is larger if aggregate risk is higher, so RWCs can lead to a positive relation between CEO incentives and aggregate risk. CEOs with RWCs willingly risk exposure to aggregate shock to keep up with their peers. This help to reduce risk premium paid to the CEOs. As a result, RWCs can be beneficial to shareholders' payoffs. I also provide a simple explanation for the pay-for-luck puzzle. I next examine the case in which the CEO's effort affects both the mean and variance of firm value. I show that RWCs can lead to a negative relation between CEOs' risk-taking behavior and their incentives, which is consistent with some empirical evidence. Lastly, I show that RWCs render options preferable to stock where aggregate risk is much larger than idiosyncratic risk.
The second chapter, "Inside Debt", is a coauthored paper with my advisor Alex Edmans. We justify the use of debt as efficient compensation. We show that inside debt is a superior solution to the agency costs of debt than the solvency-contingent bonuses proposed by prior literature, since its payoff depends not only on the incidence of bankruptcy but also firm value in bankruptcy. Contrary to intuition, granting the manager equal proportions of debt and equity is typically inefficient. The optimal ratio depends on the trade off of the importance between project selection and effort. The model generates a number of empirical predictions consistent with recent evidence.
In the last chapter, "Incentive Contracting under Ambiguity-Aversion", I study the effect of ambiguity on the pay structure of executive compensation. I show that when there is ambiguity in firm risk and if a manager is risk-averse and ambiguity-averse, stock-based contracts always impose a high risk premium. But option-based contracts can induce the manager to perceive a low risk and thus pay a low risk premium, which makes options less costly than stock. I also show that a manager tends to perceive a higher risk when she is granted higher incentives, which makes shareholders reluctant to grant managers high incentives and take advantage of some small improvements. As a result, compensation contracts exhibit an inertia property. Lastly, if ambiguity comes from the expected market returns, tying CEO pay to the market is optimal, which provides an explanation for the pay-for-luck puzzle.
Liu, Qi, "Essays on Executive Compensation" (2012). Publicly Accessible Penn Dissertations. 538.