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STOCK MARKET TRADING , PRICE FORMATION , AND OPTIMAL MANAGEMENT COMPENSATION : THEORY AND EVIDENCE

How do corporate decision-makers make use of the information conveyed by their stock prices? This paper presents a simple model in which traders’ private information is partially impounded into a firm’s stock price, which is in turn used in an optimal incentive contract for its CEO. In a sample of large US corporations, we find evidence to support the model’s prediction of a positive relationship between a CEO’s observed pay-for-performance and the information content and volume of market order flow, controlling for firm size and riskiness. We conclude that stock prices which convey more information are used more intensively in incentive contracts.