Three essays in finance
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Chapter 1 develops a model advancing a new rationale for high CEO pay - the board’s incentive to signal confidence in the CEO’s capabilities. The CEO creates value for the firm by stimulating investments from various stakeholders, such as the firm’s workers, analysts, or financiers. However, the payoffs to these investments often depend on the CEO’s ability, which is difficult for stakeholders to directly observe. The model considers one specific stakeholder interested in the board’s assessment of the CEO’s capabilities, an analyst who may produce information that will have little value if the CEO is subsequently terminated. Because the firm’s board both has private information about the CEO’s ability and sets his wage, high compensation can positively influence the analyst’s belief about the CEO’s ability, thereby increasing her incentives to collect information and improve the firm’s decision making. The model thus predicts that signaling the CEO’s capabilities is self-fulfilling: because stakeholders infer that a well-paid CEO has higher ability, they increase their investments, justifying the cost of the CEO’s compensation. Chapter 2 presents broad empirical support for the main idea and assumptions used in the theory model presented in Chapter 1. It addresses trends in corporate governance, decreasing job security for CEOs, the role of analysts as stakeholders, and various signaling mechanisms boards may use to enhance the CEO’s credibility. Chapter 3 explores how varying degrees of trader anonymity in financial markets impacts trading behavior and market characteristics. A surprising result emerges. Informed traders are not always better off with their identities protected, i.e., they may prefer to transact in relatively transparent markets. The reason is that in more transparent markets, the visibility of the informed trader’s behavior creates an incentive for him to “bluff” the market maker, sometimes trading against his information. But because the market maker understands this incentive, prices are less sensitive to order flow. Thus, more transparent markets may in fact exhibit higher levels of liquidity than more anonymous markets, conferring higher levels of expected profits to informed traders.