Stock-Based Compensation and Insider Trading with Liquidity Signal

Abstract

We study a stock-based executive (CEO) compensation contract for the case where the insider receives a signal about the demand of liquidity traders in the stock market. The single-period model of Kyle (1985) is adopted for deriving the stock market equilibrium. Based on the equilibrium stock price, the optimal linear contract for executive compensation is obtained by applying a standard principal-agent model. Surprisingly, it is found that the firm’s liquidation value is not used in the optimal executive compensation contract in both our model and the benchmark model (where there is no signal about liquidity). We also make comparative statics for the equilibrium stock price and the optimal executive compensation contract with respect to exogenous parameters.