Managerial Compensation and Outcome Volatility
2018
We present a simple discrete-time version of the continuous-time agency model under mean-volatility joint ambiguity uncertainties, which conveniently captures a number of important properties of optimal contracts without having to rely on complex continuous-time mathematical issues. The volatility ambiguity introduces two different volatilities: ex-ante perceived, and ex-post realized volatilities. The ex-post volatility in turn consists of ex-ante predictable and ex-ante purely ambiguous components. As seen in the continuous-time model, the second-best contract consists two sharing rules: one for the outcome and the other for the realized volatility. We argue that the second-best contract can help reconcile Aggarwal and Samwick (1999) and Core and Guay (2002), the two seemingly contradictory empirical studies on relationship between CEO pay and outcome volatility.
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