Executive Compensation and Short-termist Behavior in Speculative Markets

We present a multiperiod agency model of stock based executive compensation in a speculative stock market, where investors are overconfident and stock prices may deviate from underlying fundamentals and include a speculative option component. This component arises from the option to sell the stock in the future to potentially overoptimistic investors. We show that optimal compensation contracts may emphasize short-term stock performance, at the expense of long run fundamental value, as an incentive to induce managers to pursue actions which increase the speculative component in the stock price. Our model provides a different perspective for the recent corporate crisis than the increasingly popular `rent extraction view' of executive compensation.