American Finance Association

Review
Author(s): Anil Shivdasani
Review by: Anil Shivdasani
Source: The Journal of Finance, Vol. 57, No. 2 (Apr., 2002), pp. 1023-1028
Published by: Wiley for the American Finance Association
Stable URL: http://www.jstor.org/stable/2697767
Accessed: 01-03-2016 10:30 UTC

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at http://www.jstor.org/page/
info/about/policies/terms.jsp
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content
in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship.
For more information about JSTOR, please contact support@jstor.org.

American Finance Association and Wiley are collaborating with JSTOR to digitize, preserve and extend access to The Journal
of Finance.

http://www.jstor.org

This content downloaded from 14.139.249.130 on Tue, 01 Mar 2016 10:30:31 UTC
All use subject to JSTOR Terms and Conditions

Book Reviews 1023

accessible on their own. Given the length and, especially, the breadth of

Brennan's research career, one could wish that he had considered including

one or more unpublished pieces in the collection. While the quality of Bren-

nan's research means that it is unlikely there are many unpublished papers,

there is an intriguing footnote in Stewart Myers's 1977 Journal of Financial

Economics article referring to some research by Brennan in 1973 that at-

tacked the same problem but was never published.1 In a similar vein, one of

us has knowledge of a paper on the economic valuation of lease contracts

that was never submitted to a journal. The second comment is that, while

the introduction to the book is very readable and discusses some of the in-

dividual papers in brief terms, we wish that Brennan had also written a

short comment before each paper describing how he viewed that research at

the time and how his view has changed since then, if at all. This echoes, of

course, our point about the retrospective nature of the book.

In the end, however, what recommends this book most strongly is simply

that it presents a collection of excellent research papers that anyone inter-

ested in the ideas and development of modern finance should want to read.

Taken together, and noting that they represent only part of Brennan's out-

standing record of research contributions, they make very clear why his stat-

ure in the field is so high.

Alan Kraus and Jacob Sagi

University of British Columbia

The Economics of Executive Compensation. By KEVIN F. HALLOCK and

KEVIN J. MURPHY. Cheltenham, UK: Edward Elgar, 1999. Volume I:

pp. ix-xxvii + 590, Volume II: pp. 641.

The Economics of Executive Compensation is a collection of papers in ex-

ecutive compensation and financial contracting theory that is part of a se-

ries of about 135 reference collections covering the entire spectrum of

economics, published by Edward Elgar. This two-volume reference edited by

Hallock and Murphy compiles 55 of some of the most influential papers on

executive compensation.

The two volumes are organized into nine broad categories: Theoretical

Foundations of Executive Pay, Executive Compensation and Company Per-

formance, Relative Performance Evaluation, Determinants of Executive Com-

pensation, The Effects of Executive Pay, Accounting Measures in Executive

Contracts, CEO Turnover, CEO Pay Internationally, and Economic Environ-

ments and Executive Pay. Of course, these classifications are by no means

mutually exclusive, and many of the papers span more than one category. In

addition, readers interested in a specific aspect of compensation might find

relevant papers in several parts of the book. For example, a reader inter-

1 We thank Ron Giammarino for reminding us of this reference.

This content downloaded from 14.139.249.130 on Tue, 01 Mar 2016 10:30:31 UTC
All use subject to JSTOR Terms and Conditions

1024 The Journal of Finance

ested in compensation and the managerial labor market would find impor-

tant articles in each of Parts 1, III, and IV of Volume I. Nonetheless, the

editors have done a nice job of organizing the papers across different cat-

egories and some trade-offs in organization are probably unavoidable.

Unlike many reference collections, where the selection of papers is heavily

influenced by the editor(s), Hallock and Murphy adopt a fairly systematic

approach to selecting papers for this collection. They aim to include the most

influential papers in each of the nine categories above by picking those with

the highest citation counts. Starting from a list of over 500 published pa-

pers, they rank all papers on both total citations and citations per year over

the 1971 to 1996 period using SSCI. Although the editors generally included

the most widely cited papers, the selection process did not escape their per-

sonal judgment entirely. In a few cases, they include recent papers that have

not had time to build up citations and also some older and slightly forgotten

papers. The papers are primarily drawn from the economics and finance

literature, even though the topic of executive compensation has received a

fair bit of attention in other disciplines such as law and economics, manage-

ment strategy, and organizational behavior.

The reliance on citations in selecting papers has both advantages and draw-

backs. By construction, the authors end up with a collection of papers that

are well known and have had a big influence on the literature. Thus, most

researchers in the area will be familiar with many of the papers in this

collection. This makes the collection most useful to compensation research-

ers as a handy reference or to those not intimately familiar with the liter-

ature. At the same time, relying on citations tends to avoid papers that are

more recent or controversial. Anyone using this book in a doctoral seminar

will thus probably want to supplement the book with more recent and/or

controversial papers that might not have had the time to be part of estab-

lished thought in the field.

Partly to facilitate this process, Hallock and Murphy provide an excellent

overview of the executive compensation literature and do a nice job of link-

ing the papers that they select to the broader literature on compensation. I

found that the introduction proved to be the most enjoyable reading in this

book and I recommend it to anyone interested in a quick overview of this

vast literature. The papers in the two volumes are published as stand-alone

pieces, and the overview is helpful in linking them together.

With 55 papers in this collection, it is impossible to discuss them in much

depth. Therefore, I will focus my review on briefly describing the papers

that Hallock and Murphy select. These papers are italicized below and are

unreferenced. References are listed, however, for my suggestions on papers

that were not selected, but might be worth reading.

Part I of Volume I covers the theoretical foundations of executive compen-

sation. Since much of the literature is rooted in agency costs, it is fitting

that the seminal work of Jensen and Meckling (1976) is the first paper in the

volume. Part I also includes the other classics of compensation theory such

as Holmstrom (1979), Holmstrom (1982), Grossman and Hart (1983), and

This content downloaded from 14.139.249.130 on Tue, 01 Mar 2016 10:30:31 UTC
All use subject to JSTOR Terms and Conditions

Book Reviews 1025

Lazear and Rosen (1981), whose analysis of the principal-agent problem

lays the foundation of much of the subsequent empirical literature on com-

pensation. Fama (1980) introduces the concept of the managerial labor mar-

ket in controlling agency costs. In a departure from the agency cost paradigm,

Rosen (1982) theorizes how the distribution of firm size and executive com-

pensation is determined by market assignment of executives within hierar-

chies. However, much of the subsequent empirical literature on compensation

has evolved within the agency cost paradigm.

Part II of Volume I covers papers that document the shape of the pay-

performance relation. Rosen (1992) surveys some of this literature, and high-

lights the regularity that the elasticity of CEO compensation to firm size is

about 0.3. Lewellen and Huntsman (1970) is one of the earliest papers to

show that CEO salaries are positively related to accounting profits. Not sur-

prisingly, this section also includes key papers by Murphy (1985) and Coughlan

and Schmidt (1985), which show that changes in compensation are related

to stock returns. Jensen and Murphy's (1990) influential study shows that

on average CEO compensation changes by only $3.25 for every $1,000 change

in shareholder wealth. Jensen and Murphy question whether this elasticity

is sufficiently strong to provide meaningful incentives to CEOs. This finding

has spawned several papers that explore this finding further. Haubrich (1994)

shows that numerical solutions obtained by parameterizing the principal-

agent models of Grossman and Hart and Holmstrom and Milgrom yield es-

timates of the pay to performance sensitivities that are actually quite close

to those documented by Jensen and Murphy. Readers of the book may also

find three other papers that are not included to be of interest. Hadlock and

Lumer (1997) use historical data to show that the pay-performance sensi-

tivity has increased over time. They make the point that though Jensen and

Murphy's estimates appear low, they are actually high by historical stan-

dards. This trend toward higher pay to performance sensitivity seems to be

continuing. Hall and Leibman (1998) show that the sensitivity of CEO com-

pensation to performance has risen sharply since 1980, largely because of

increases in stock option grants. More recently, Perry and Zenner (2000)

document that the pay-performance sensitivity has increased substantially

since 1993, following changes in the tax code limiting the deductibility of

nonperformance compensation over $1 million. They find that the increase

in sensitivity is most noticeable for firms subject to the million-dollar salary

cap.

Part III covers a specific aspect of compensation contracts, namely whether

executives are evaluated on an absolute or relative basis. Holmstrom (1979,

1982) shows that it can be optimal to base contracts on measures of other

agents' performance if these measure are informative about the agent's per-

formance. Antle and Smith (1986) explore whether compensation contracts

evaluate a CEO's performance relative to the performance of competitors,

but find mixed results. Gibbons and Murphy (1990) find some evidence show-

ing relative performance evaluation exists for salary and bonus. However,

since most of the incentives for CEOs come from stock and option holdings,

This content downloaded from 14.139.249.130 on Tue, 01 Mar 2016 10:30:31 UTC
All use subject to JSTOR Terms and Conditions

1026 The Journal of Finance

the bulk of CEO rewards tend to be insensitive to relative performance mea-

sures. This section of the book highlights the discrepancy between theory

and data on this issue. More recently, however, Coles, Suay, and Woodbury

(2000) have shown that closed-end funds employing relative performance

measures for compensating fund advisors are associated with a significantly

larger premium, supporting Holmstrom's analyses.

Part IV of Volume I is devoted to papers on the determinants of executive

compensation. Murphy (1986) presents weak evidence that the sensitivity of

pay to performance decreases as CEO tenure rises, suggesting that as boards

uncover CEO ability over time, there is less need for revisions in wages.

Other papers in this section examine the effects of stock-based pay. Lambert,

Lareker, and Verrecchia (1991) show that the value of stock-based pay to

managers can be much less than its cost to shareholders because of mana-

gerial risk aversion. However, the recent explosion in option-based compen-

sation among firms in the United States seems to suggest that the costs of

managerial risk aversion pale in comparison to the perceived incentive ben-

efits associated with equity-based compensation. Further, Ofek and Yer-

mack (2000) show that CEOs often take offsetting transactions to manage

their exposure to option grants. Although the recent publication date of Ofek

and Yermack (2000) precludes inclusion in this volume, readers interested in

this aspect of compensation would find the paper a useful addition.

O'Reilly, Main, and Crystal (1988) argue that CEO pay is determined by

comparison to pay for other CEOs, and that tournament theory is not help-

ful in understanding compensation levels. Leonard (1990), however, presents

evidence supportive of tournament theory in determining pay levels. The

other papers focus on the mix of equity and fixed compensation provided to

executives. Gibbons and Murphy (1992) show that pay to performance sen-

sitivity increases as CEOs approach retirement age. Thus, compensation con-

tracts need to provide stronger incentives because of the reduced importance

of the external managerial labor market for CEOs due to retire shortly. Lewel-

len, Loderer, and Martin (1987) find similar results and also show that the

equity-based component of total compensation is higher for firms with at-

tractive growth opportunities and that stock-based pay discourages exces-

sively conservative investment policies. Yermack (1995), however, questions

the degree to which compensation contracts are designed to mitigate agency

costs between managers and shareholders. He finds that variables measur-

ing the potential for agency conflicts lack explanatory power for understand-

ing the size of CEO stock option awards.

Part I of Volume II includes papers by Masson (1971) and Abowd (1990)

that ask whether higher pay-performance sensitivities lead to better corpo-

rate performance. Abowd (1990) finds evidence that higher sensitivity leads

to better subsequent stock returns. However, given the well-known issues of

risk adjustment and statistical inference in interpreting long-term returns,

this finding is in my view, not very convincing. More straightforward evi-

dence is presented by Brickley, Bhagat, and Lease (1985) and Tehranian and

Waegelein (1985), who show that incentive compensation plans have positive

This content downloaded from 14.139.249.130 on Tue, 01 Mar 2016 10:30:31 UTC
All use subject to JSTOR Terms and Conditions

Book Reviews 1027

announcement returns. Agrawal and Mandelkar (1987) analyze firms' in-

vestment and financing choices and argue that option holdings reduce agency

problems between managers and shareholders. In a similar spirit, Dechow

and Sloan (1991) find that high stock ownership is helpful in aligning manager-

shareholder incentives when CEOs approach retirement. Brown, Harlow, and

Starks (1996) suggest that incentive plans affect incentives to take on risky

investments. They find that poorly performing fund managers increase port-

folio risk towards the end of the year, whereas well performing managers

lower portfolio risk. While all these papers provide useful evidence, it will be

helpful to readers to keep in mind that these effects of incentive plans are

not universally established. For example, May (1995) shows that high man-

agerial ownership creates incentives to pursue diversifying acquisitions.

Part II contains papers that document the prevalence of accounting-based

performance metrics in compensation contracts. Bushman and Indejejikian

(1993) and Sloan (1993) describe issues in using accounting versus stock-

price based metrics for incentive compensation. Healy (1985), Gaver et al.

(1995), and Holthausen et al. (1995) show that inclusion of accounting met-

rics creates incentives for opportunistic earnings management to boost man-

agerial compensation.

Parts III and IV of the book are devoted to CEO turnover and to inter-

national evidence on the pay-performance link. Since detailed international

compensation data is usually lacking, estimating the turnover-performance

link instead can be indicative of the incentives facing managers in other

economies. Papers by Coughlan and Schmidt (1985), and Warner, Watts, and

Wruck (1988) show that top management turnover is inversely related to

firm performance. Murphy and Zimmerman (1993) study changes in a broad

set of financial variables around CEO turnover. Estimating the turnover-

performance relation has now become a standard technique to judge the

efficacy of corporate governance forces and mechanisms. For example, Weis-

bach (1988) shows that this relation is strengthened when outsider directors

dominate the board. Kaplan (1994a) and Kang and Shivdasani (1995) dem-

onstrate a similar turnover-performance relation in Japan, and Kaplan (1994b)

finds similar evidence in Germany. Conyon et al. (1995) provide evidence on

compensation among U.K. firms, and Abowd and Bognanno (1995) conduct

an interesting comparison of compensation in 11 developed countries.

The concluding part of this collection contains papers which relate exec-

utive compensation to the economic environment. Using industry-level analy-

sis, Smith and Watts (1992) show that executive compensation varies

systematically with a firm's investment opportunity set and the degree of

regulation. Joskow et al. (1995) find that regulatory constraints in the elec-

tric utility industry limit the level of CEO pay. In an analysis of deregulation

in the banking industry, Hubbard and Palia (1995) demonstrate that CEO

compensation tends to be less sensitive to performance in regulated envi-

ronments. Gilson and Vetsuypens (1993) show how compensation contracts

are altered in financial distress to also provide incentives to increase the

value of creditors' claims.

This content downloaded from 14.139.249.130 on Tue, 01 Mar 2016 10:30:31 UTC
All use subject to JSTOR Terms and Conditions

1028 The Journal of Finance

In summary, these volumes represent an impressive collection of articles

and include most of the well-known papers in the executive compensation

literature over the last three decades. In this regard, it is hard to debate the

choice of papers by Hallock and Murphy. As is usually the case with collec-

tions, however, it is easy to think of other studies that interested readers

would also find useful to review. For example, the recent explosion in CEO

pay levels, much of which has been driven by a rapid rise in the value of

stock option awards, has caused increased attention on whether large awards

represent excessive compensation. Yermack's (1997) finding that stock prices

rise prior to the news of option awards becoming public knowledge suggests

the possibility of opportunistic timing of option compensation. It seems likely

that future work in this area will explore the degree to which agency costs

drive the design of compensation packages and the circumstances in which

suboptimal contracts are observed and the forces that curtail such subopti-

mality. In the meantime, researchers interested in executive compensation

will find this collection to be a worthwhile investment.

REFERENCES

Coles, Jeffrey L., Jose Suay, and Denise Woodbury, 2000, Fund advisor compensation in closed

end funds, Journal of Finance 55, 1385-1414.

Hadlock, Charles J. and Gerald B. Lumer, 1997, Compensation, turnover, and top management

incentives: Historical evidence, Journal of Business 70, 153-187.

Hall, Brian J., and Jeffrey B. Leibman, 1998, Are CEOs really paid like bureaucrats? Quarterly

Journal of Economics 113, 653-691.

Kang, Jun-Koo, and Anil Shivdasani, 1995, Firm performance, corporate governance, and top

executive turnover in Japan, Journal of Financial Economics 38, 29-58.

May, Don O., 1995, Do managerial motives influence firm risk reduction strategies? Journal of

Finance 50, 1291-1308.

Ofek, Eli, and David Yermack, 2000, Taking stock: Equity-based compensation and the evolu-

tion of managerial ownership, Journal of Finance 55, 1367-1384.

Perry, Todd, and Marc Zenner, 2001, Pay for performance? Government regulation and the

structure of compensation contracts, Journal of Financial Economics (62)3, 453-488.

Yermack, David, 1997, Good timing: CEO stock option awards and company news announce-

ments, Journal of Finance 52, 449-476.

Anil Shivdasani1

University of North Carolina-Chapel Hill

Pricing Derivative Securities. By T. W. EPPS. Singapore: World Scientific,

2000. Pp. xviii + 694.

This is a comprehensive book and a valuable addition to the literature.

Presented in three sections, it gives the mathematical background required

for modern financial theory, the applications of these results to derivative

pricing and, in a final section, a preliminary discussion of the related nu-

merical methods.

1 I thank David Yermack and Marc Zenner for helpful comments.

This content downloaded from 14.139.249.130 on Tue, 01 Mar 2016 10:30:31 UTC
All use subject to JSTOR Terms and Conditions