Optimal CEO Incentive Contracts: A Prospect Theory Explanation

Abstract

This study examines the relationship between CEO incentive-based compensationand firm performance, based on the role of prospect theory in executivecompensation. Our results indicate that moderate levels of performance-based CEOcompensation are generally optimal. When an executive’s total compensation packageis based more on firm performance there is often a level of higher returns, but toa point of diminishing return. Our findings suggest that boards must clearly communicatewith 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.