Talking down the firm: Short-term market manipulation and optimal management compensation

This paper analyzes the optimal use of short- and long-term share prices 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 fluctuations. However, if the manager has private information that is relevant 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-term share price and so raise perceptions of her value added. These results endogenize corporate managers' concern with short-term stock market fluctuations, and show how manipulation can occur even with optimal contracts.