This paper analyzes optimal executive compensation contracts when managers are loss averse. We show that optimal contracts consist of an upward sloping compensation function and a threshold value for the value of the firm below which the manager is
fired and suffers a discrete loss of compensation. We parameterize the model using data on compensation contracts and parameters for preferences suggested by the experimental literature.
For a representative CEO, we estimate the optimal contract predicted by the model and
discuss its comparative static properties. It turns out that the model’s predictions are
remarkably accurate and that it can explain the use of stock options as part of an optimal
contract. The approximation is about one order of magnitude better than those from reasonable parameterizations of the conventional principal agent model with constant relative
risk aversion.
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