TALKING DOWN THE FIRM - SHORT-TERM MARKET MANIPULATION AND OPTIMAL MANAGEMENT COMPENSATION

This paper analyzes the optimal use of short-and long-term share price s in management incentive contracts. A key innovation of our model is that the short-term share price is determined even before the manager has made her effort choice and therefore cannot be informative in the standard principal-agent sense. We show that when traders on the short -term market have as much information as the manager does, the optimal contract fully insures the manager against short-term share price flu ctuations. However, if the manager has private information that is rel evant to the short-term share price and is fully insured then she will have an incentive to 'talk down the firm'--to manipulate the short-te rm share price and so raise perceptions of her value added. These resu lts endogenize corporate managers' concern with short-term stock marke t fluctuations, and show how manipulation can occur even with optimal contracts. (C) 1998 Elsevier Science B.V.