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Stock Options and Managerial Optimal Contracts

In this paper we are concerned with the performance of stock option contracts in the provision of managerial incentives. In our simple framework, we restrict the space of contracts available to the principal to those conformed by a fixed payment and a package of call options on the firm's stock. We then offer a characterization of optimal stock option compensation schemes. As compared to the fixed payment and the option grant, we find that the strike price plays an intermediate role in the provision of insurance and incentives. We also develop some efficient algorithms for the computation of optimal contracts in which the observable outcome is drawn from a continuous distribution. These algorithms are useful to address some important issues such as the calibration of a principal-agent model, the degree of risk aversion compatible with current compensation schemes, and the performance of stock option contracts.

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Paper provided by Department of Economics, W. P. Carey School of Business, Arizona State University in its series Working Papers with number 2133304.

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Handle: RePEc:asu:wpaper:2133304
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  1. Gian Luca Clementi & Thomas F. Cooley, . "Sensitivity of CEO Pay to Shareholder Wealth in a Dynamic Agency Model," GSIA Working Papers 2002-E13, Carnegie Mellon University, Tepper School of Business.
  2. Robert Gibbons & Kevin J. Murphy, 1991. "Optimal Incentive Contracts in the Presence of Career Concerns: Theory and Evidence," NBER Working Papers 3792, National Bureau of Economic Research, Inc.
  3. Haubrich, Joseph G, 1994. "Risk Aversion, Performance Pay, and the Principal-Agent Problem," Journal of Political Economy, University of Chicago Press, vol. 102(2), pages 258-76, April.
  4. Laffont, Jean-Jacques & Tirole, Jean, 1986. "Using Cost Observation to Regulate Firms," Journal of Political Economy, University of Chicago Press, vol. 94(3), pages 614-41, June.
  5. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-28, March.
  6. R. Preston McAfee & John McMillan, 1987. "Competition for Agency Contracts," RAND Journal of Economics, The RAND Corporation, vol. 18(2), pages 296-307, Summer.
  7. Page, Frank Jr., 1987. "The existence of optimal contracts in the principal-agent model," Journal of Mathematical Economics, Elsevier, vol. 16(2), pages 157-167, April.
  8. Phelan, Christopher & Townsend, Robert M, 1991. "Computing Multi-period, Information-Constrained Optima," Review of Economic Studies, Wiley Blackwell, vol. 58(5), pages 853-81, October.
  9. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  10. Joseph G. Haubrich & Ivilina Popova, 1994. "Executive compensation: a calibration approach," Working Paper 9416, Federal Reserve Bank of Cleveland.
  11. Bengt Holmstrom, 1999. "Managerial Incentive Problems: A Dynamic Perspective," NBER Working Papers 6875, National Bureau of Economic Research, Inc.
  12. Edward S. Prescott, 1998. "Computing moral-hazard problems using the Dantzig-Wolfe decomposition algorithm," Working Paper 98-06, Federal Reserve Bank of Richmond.
  13. Santos, Manuel S., 1999. "Numerical solution of dynamic economic models," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 5, pages 311-386 Elsevier.
  14. Bengt Holmstrom & I. Ricard & Joan Costa, 1984. "Managerial Incentives and Capital Management," Cowles Foundation Discussion Papers 729, Cowles Foundation for Research in Economics, Yale University.
  15. Wang, C., 1995. "Incentives, CEO Compensation, and Shareholder Wealth in a Dynamic Agency Model," GSIA Working Papers 1995-08, Carnegie Mellon University, Tepper School of Business.
  16. Hall, Brian J. & Murphy, Kevin J., 2002. "Stock options for undiversified executives," Journal of Accounting and Economics, Elsevier, vol. 33(1), pages 3-42, February.
  17. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 653-691, August.
  18. Guillermo Caruana & Marco Celentani, 2001. "Career Concerns And Contingent Compensation," Economics Working Papers we014811, Universidad Carlos III, Departamento de Economía.
  19. Edward S. Prescott, 1999. "A primer on moral-hazard models," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 47-78.
  20. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563 Elsevier.
  21. Prendergast, Canice & Stole, Lars, 1996. "Impetuous Youngsters and Jaded Old-Timers: Acquiring a Reputation for Learning," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1105-34, December.
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