Optimal CEO Incentive Contracts: A Prospect Theory Explanation

Abstract

This study examines the relationship between CEO incentive-based compensation
and firm performance, based on the role of prospect theory in executive
compensation. Our results indicate that moderate levels of performance-based CEO
compensation are generally optimal. When an executive’s total compensation package
is based more on firm performance there is often a level of higher returns, but to
a point of diminishing return. Our findings suggest that boards must clearly communicate
with CEOs to determine the most appropriate levels of incentive-based compensation.
Additional managerial and theoretical implications are offered, as well as avenues for future research.