Speculative Market Behavior and Employee Compensation

In the past decades, we observe that some firms grant stock-based pay to many of their middle-level managers, engineers or even secretaries and sales. Since stock price is not a good measure of those workers, this kind of compensation plan only awards or punishes them with luck. This paper proposes an answer to the question why firms have been granting stock options to their rank-and-file employees, by linking the speculative trading behavior in the stock market to compensation decision inside a firm. In the theory, there are two sides: stock market and the firm. On market's side, I make a shortcut assumption that investors may interpret public signals in different ways so that they hold different views about the prospective of the firm from time to time. By holding one share of the stock, an investor not only reaps the dividends but also gets the OPTION to resell the stock share at some time to some investor who is more optimistic about the firm's future value. When there are limits to short sales, this speculative behavior makes the stock price higher than the firm's discounted sum of expected dividends in every period. This additional value is called resale premium. The more disagreement in the market, the higher is the resale premium. Now we look at the firm. Suppose that the CEO is delegated the decision-making right of employee compensation, and he has commitment to long-term stock holding or he is restricted from speculative trading. This implies that he faces more liquidity constraints on stock transaction. When the stock market is speculative, he doesn't enjoy the resale premium incorporated in the stock price. This creates a wedge between the values of stock holding by the CEO and by other investors. The CEO then use firm equities (basically stock options) as cheaper instruments to compensate his employees. Indirectly, the market bubbles pay for these compensations. When there is more disagreement in the market, there is higher trading volume. At the same time, the cheaper is the firm equities for CEO so that he tends to give more equity-based compensation to his employees. In this way, we establish an empirical implication that there is positive correlation between stock options granted to non-executive employees and market trading behavior. Using ExecuComp data set from 1992 to 2002, our sample covers the rise and fall of the stock market. We use stock turnover rate as an indicator of disagreements and find out that the effect of turnover rate is significant and robust to choice of control variables and empirical methods. This finding is new to the literature.