Implicit contracts and the explanatory power of top executive compensationfor future performance

Recent research suggests that implicit incentive contracts may be based on performance measures that are observable only to the contracting parties. W e derive and test implications of this insight for the relationship between executive compensation and firm performance. if corporate boards optimally use both observable and unobservable (to outsiders) measures of executive performance and the unobservable measures are correlated with future firm p erformance, then unexplained variation in current compensation should predi ct future variation in firm performance. Further, compensation should be mo re positively associated with future performance when observable measures a re less useful for contracting, Our results are consistent with these hypot heses.