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.

ABSTRACT 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.

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.