Stock-based pay, liquidity, and the role of market making

We study the role of stock market characteristics on managerial compensation. A risk averse manager exerts an unobservable effort that drives future firm value. The value cannot be used in the incentive contract because it realizes in the distant future and compensating the manager cannot be postponed until then. The stock price emerges endogenously because of trading by informed and uninformed traders in a standard competitive noisy rational expectations equilibrium model. We identify new “skin-in-the-game” and “information-overlap” terms in the weights the optimal incentive contract gives to the stock price and to public information. We derive novel comparative statics, e.g., the manager may receive more stock-based pay when traders' information becomes worse. The contract always uses public information except in the special case when uninformed traders are risk-neutral.