This paper analyzes the incentives of large shareholders to monitor public corporations. We investigate the hypothesis that a liquid stock market reduces large shareholders' incentives to monitor because it allows them to sell their stocks more easily. Even though this is true, a liquid market also makes it less costly to hold larger stakes and easier to purchase additional shares. We show that this fact is important if monitoring is costly: market liquidity mitigates the problem that small shareholders free ride on the effort of the large shareholder. We find that liquid stock markets are beneficial because they make corporate governance more effective. IS A LIQUID STOCK MARKET a liability for effective corporate governance? Casual empiricism seems to suggest that a liquid market allows investors to sell out if they receive adverse information about a company, and that, by contrast, a less liquid market forces them to hold on to their investment and to use their votes to influence the company to achieve better returns. A typical example is British Airways' experience, when its senior management came under attack for using unfair competitive practices against one of its smaller rivals, Virgin Atlantic. At the time, the Financial Times noted that Fidelity, the second largest shareholder with a holding of 4.5 percent, "has disposed of almost its entire position, and the Prudential and Standard Life stakes have

We calibrate the standard principal-agent model with constant relative risk aversion and lognormal stock prices to a sample of 598 U.S. CEOs. We show that this model predicts that most CEOs should not hold any stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies; many would be required to purchase additional stock in their companies. These contracts would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We conclude that the standard principal-agent model typically used in the literature cannot rationalize observed contracts. Copyright 2007 by The American Finance Association.

We estimate a standard principal agent model with constant relative risk aversion and lognormal stock prices for a sample of 598 US CEOs. The model is widely used in the compensation literature, but it predicts that almost all of the CEOs in our sample should hold no stock options. Instead, CEOs should have lower base salaries and receive additional shares in their companies. For a typical value of relative risk aversion, almost half of the CEOs in our sample would be required to purchase additional stock in their companies from their private savings. The model predicts contracts that would reduce average compensation costs by 20% while providing the same incentives and the same utility to CEOs. We investigate a number of extensions and modi…cations of the standard model, but …nd none of them to be satisfactory. We conclude that the standard principal agent model typically used in the literature cannot rationalize observed contracts. One reason may be that executive pay contracts are suboptimal.JEL Classi…cation: G30, M52

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This paper analyzes optimal executive compensation contracts when managers are loss averse.We calibrate a stylized principal-agent model to the observed contracts of 595 CEOs and show that this model can explain observed option holdings and high base salaries remarkably well for a range of parameterizations. We also derive and calibrate the general shape of the optimal contract that is increasing and convex for medium and high outcomes and drops discontinuously to the lowest possible payout for low outcomes. We identify the critical features of the loss-aversion model that render optimal contracts convex.

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