Information-Based Stock Trading, Executive Incentives, and the Principal-Agent Problem

We examine the role of information-based stock trading in affecting the risk-incentive relation. By incorporating an endogenous informed trading into an optimal incentive contracting model, we analytically show that, apart from reducing incentives, a greater risk increases the level of information-based trading which consequently enhances executive incentives and offsets the negative risk-incentive relation. We calibrate the model and find that the economic magnitude of this incentive-enhancement effect is significant. Our empirical test using real-world executive compensation data lends strong support to the model prediction. Our results suggest that principals (boards of directors) should consider underlying stock trading characteristics when structuring executive incentives. JEL Classification: D80, G14, G30, J33