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Good news about a CEO's ability creates a positive surplus. Empirically, CEOs capture most of this surplus by bidding up their pay. However, CEOs bear almost none of the negative surplus resulting from bad news about ability. These results are consistent with the optimal contracting benchmark of Harris and Holmstrom (1982). Since CEOs do not capture their entire surplus, CEO ability matters more for shareholders, which is supported by predictions and data on unanticipated CEO deaths. The model helps explain the sensitivity of CEO pay to lagged returns, and also the changes in return volatility around CEO successions.
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