Standard principal-agent theory prescribes that managers should not be compensated on exogenous risks, such as general market movements. Rather, firms should index pay and use contracts that filter exogenous risks (e.g., Holmstrom 1979, 1982; Diamond and Verrecchia 1982). This prescription is intuitive and agrees with common sense: CEOs should receive exceptional pay only for exceptional performance, and “rational” compensation practice should not permit CEOs to obtain windfall profits in rising stock markets. However, observed compensation contracts are typically not indexed. Specifically, stock options almost never tie the strike price of the option to an index that reflects market performance or the performance of peers. Commentators often cite this glaring difference between theory and practice as evidence for the inefficiency of executive compensation practice and, more generally, as evidence for major deficiencies of corporate governance in U.S. firms (e.g., Rappaport and Nodine 1999; Bertrand and Mullainathan 2001; Bebchuk and Fried 2004). This paper therefore contributes to the discussion about which compensation practices reveal deficiencies in the pay-setting process.

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