Search for optimal CEO compensation: theory and empirical evidence’, Working Paper

There are two stylized facts that standard theories on executive compensation are inca-pable of explaining: 1) there is no definitive empirical relation between pay-to-performance-sensitivity and a firm’s total risk; 2) in recent decades, executive compensation and firm size have increased steadily. We propose a dynamic equilibrium agency model to resolve these standing issues. Our theoretical and empirical analyses show that the indeterminate relation between pay-to-performance-sensitivity and total risk is due to the diametrically opposing effects of firm-specific risk and systematic risk on pay-to-performance-sensitivity, and the increases in executive compensation and firm size are mainly driven by a steadily growing economy