Economists have long argued that a strong linkage between compensation and performance is essential for resolving the agency problem created by the separation of ownership and control. In particular Michael C. Jensen and Kevin J. Murphy (1990) were very influential in giving impetus to the view that such incentives were in need of strengthening. Compared to accounting benchmarks, the stock price is more forward looking, and it is responsive to all value-relevant information, including informal and unverifiable items of news. This makes stock and/or option awards an important part of optimal incentives, and constitutes a primary reason for seeking a public listing, as argued by Bengt Holmstrom and Jean Tirole (1993). Until recently, however, theories of optimal executive compensation have generally ignored the possibility that the stock price can be manipulated or falsified. It is becoming increasingly clear that this is an important issue. In a spate of recent scandals, companies have misled the investing public by vastly overstating their profitability and prospects, and substantive restatements of company accounts have become increasingly commonplace. A growing body of empirical evidence suggests that executive pay in its current form may be at least in part responsible. Recent studies finding a link between unusual movements in performance measures (such as accounting yardsticks and publicly disclosed price-sensitive information) and compensation include Daniel Bergstresser and Thomas Philippon (2006), Natasha Burns and Simi Kedia (2006), and Peng and Roell (forthcoming). Thus, the benefits of stock-based incentives should be weighed against their side effects. This paper models optimal executive compensation in a setting where managers are in a position to influence the public perception of Manipulation and Equity-Based Compensation

We present a rational expectations model of optimal executive compensation in a setting where managers are in a position to manipulate short‐term stock prices and the manipulation propensity is uncertain. We analyze the tradeoffs involved in conditioning pay on long‐ versus short‐term performance and show how manipulation, and investors' uncertainty about it, affects the equilibrium pay contract and the informativeness of prices. Firm and manager characteristics determine the optimal compensation scheme: the strength of incentives, the pay horizon, and the use of options. We consider how corporate governance and disclosure regulations can help create an environment that enables better contracting.

Market liquidity is impacted by the presence of financial intermediaries that are informed and active participants in both the equity and the syndicated bank loan markets, specifically informationally advantaged lead arrangers of syndicated bank loans that simultaneously act as equity market makers (dual market makers). Employing a two-stage procedure with instrumental variables, we identify the simultaneous equations model of liquidity and dual market maker decisions. We find that the presence of dual market makers improves the liquidity of the more competitive and transparent equity markets, but widens the spread in the less competitive over-the-counter loan market, particularly for small, informationally opaque firms.

Motivated by psychological evidence that attention is a scarce cognitive resource, we model investors’ attention allocation in learning and study the effects of this on asset-price dynamics. We show that limited investor attention leads to category-learning behavior, i.e., investors tend to process more market and sector-wide information than firm-specific information. This endogenous structure of information, when combined with investor overconfidence, generates important features observed in return comovement that are otherwise difficult to explain with standard rational expectations models. Our model also demonstrates new cross-sectional implications for return predictability.

We present resiliency as a measure of liquidity and assess its relationship to expected returns. We establish a covariance-based measure, RES, that captures opening period resiliency, and use it to find a significant nonresiliency premium that ranges from 33 to 57 basis points per month. The premium persists after accounting for an extensive list of other liquidity-related measures and control variables. The results are significant for both value-weighted and equal-weighted returns, when micro-cap stocks are excluded, and for a sample of large cap stocks. The premium is particularly pronounced when trading volume is high.

We find that the stock market underreacts to stock-level liquidity shocks: liquidity shocks are not only positively associated with contemporaneous returns, but they also predict future return continuations for up to six months. Long-short portfolios sorted on liquidity shocks generate significant returns of 0.70% to 1.20% per month that are robust across alternative shock measures and after controlling for risk factors and stock characteristics. Furthermore, we show that investor inattention and illiquidity contribute to the underreaction: while both are significant in explaining short-term return predictability of liquidity shocks, the inattention-based mechanism is more powerful for the longer-term return predictability.

We document distinctly different clientele effects on investor attention and return responses to information. Macro news crowds out retail investor attention to firms’ earnings news by 49%. For stocks with high retail ownership, macro news dampens earnings announcement returns by 17% and substantially increases post-announcement drift, especially during high VIX periods. In contrast, macro news increases institutional investor attention to scheduled earnings announcements but not their attention to unscheduled analysts’ forecast revisions. The findings confirm the implications of rational inattention models and highlight the importance of considering clientele effects in understanding the effect of news on attention and asset prices.

We study how the social transmission of public news influences investors’ beliefs and the securities markets. Using data on social networks, we find that earnings announcements from firms in higher-centrality counties generate a stronger immediate price, volatility, and trading volume reactions. Post-announcement, such firms experience weaker price drift and faster volatility decay but higher and more persistent volume. These findings suggest greater social connectedness facilitates the timely incorporation of news into prices, as well as opinion divergence and excessive trading. We propose the social churning hypothesis, which is confirmed using granular data from StockTwits messages and household trading records.

We show that institutional investors are more likely to invest in firms from regions to which they have stronger social ties but find no evidence that these investments earn a differential return. Firms in regions with stronger social ties to locations with many institutional investors have higher valuations and liquidity. These effects are largest for small firms with little analyst coverage, suggesting that the investors’ behavior is explained by their increased awareness of firms in socially proximate locations. Our results highlight that the social structure of regions affects firms’ access to capital and contributes to geographic differences in economic outcomes.