Outside opportunities and termination

We study a dynamic principal-agent relationship where a stochastic outside opportunity (offer) arises each period for the risk averse agent. Termination is costly, but it allows the agent to pursue the available outside opportunity and the principal to return to an external market to hire a new agent. The principal acts strategically with respect to the agent's outside offers and we show that it is optimal to terminate the current relationship if and only if the agent's outside offer is above a cutoff level. The optimal contract generates both voluntary and involuntary terminations. Severance compensation arises endogenously and we show that it may be paid only in involuntary terminations. Conditional on termination, the size of the optimal severance compensation depends positively on the agent's current compensation, but negatively on his outside offer. The optimal contract dictates an inverted-U relationship between compensation and the probability of termination.