The Complexity of CEO Compensation: Incentives and Learning

I study what are the firm characteristics that may justify the use of options or refresher grants in the compensation packages for CEOs as part of an optimal contract in the presence of moral hazard. I model explicitly the determination of stock prices from the output realizations of the firm: Symmetric learning by all players about the exogenous quality of the firm makes stock prices sensitive to output observations. Compensation packages become an instrument to transform this sensitivity of prices to output into the optimal sensitivity of consumption to output that is dictated by the optimal contract. Heterogeneity in the structure of firm uncertainty implies that some firms are able to implement the optimal contract with very simple schemes that do not contain options, refresher grants, or perks, while others necessarily need to use these more complex and non--transparent instruments.