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Principal agent problems under loss aversion: an application to executive stock options

  • David de Meza
  • David C. Webb

Executive stock options reward success but do not penalise failure. In contrast, the standard principalagent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, the use of carrots but not sticks is a feature of an optimal compensation contract. Low risk aversion and high loss aversion is particularly propitious to the use of options. Moreover, loss aversion on the part of executives explains the award of at the money options rather than discounted stock or bonus related pay. Other features of stock option grants are also explained, such as resetting or reloading with an exercise price equal to the current stock price.

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File URL: http://eprints.lse.ac.uk/24676/
File Function: Open access version.
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Paper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24676.

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Length: 24 pages
Date of creation: Jan 2004
Date of revision:
Handle: RePEc:ehl:lserod:24676
Contact details of provider: Postal: LSE Library Portugal Street London, WC2A 2HD, U.K.
Phone: +44 (020) 7405 7686
Web page: http://www.lse.ac.uk/

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