Risk-taking, Rent-seeking, and CEO compensation, when Financial Markets are Noisy

We analyze investment incentives and risk-taking by firms when equity markets aggregate information with noise. Noisy information aggregation drives a wedge between the expected social value and the market value of investments, inducing inefficient rent-seeking by incumbent shareholders and corporate short-termism. Excessive risk taking is particularly severe if upside risks are coupled with near constant returns to scale, in which case even small market frictions lead to negative social value, but large shareholder rents. The optimal contract design incentivizes excessive risk-taking through the grant of stock options, or discourages risk-taking through through the use of compensation ceilings. Finally we compare different regulatory or policy interventions and argue that limiting executive incentives to restricted equity contracts may be the most e§ective way to eliminate investment distortions.