Noise Pollution: Why Optimal Contracts Expose Managers to Short-Term Market Movements

Abstract

This paper analyzes the optimal use of short and long-term share prices in management incentive contracts. We assume that the short-term share price is determined even before the manager has made her effort choice and, therefore, cannot be informative in the standard principal-agent sense. We show that when share traders have as much information as the firm does, the short-term share price is used to index the manager's compensation, and she is paid only according to returns over and above the short-term share price. We then allow the manager to have some private information that is relevant to the short-term share price. In this case, full indexation is impossible and the manager's optimal pay will depend not only on long-term "fundamantals" but also on short-term stock prices. This result endogenizes corporate managers' concern with short-term stock market fluctuations.

JEL Classification: D23, G30