Stock options for undiversified executives

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4. Stock Options for Undiversified Executives - Article - Faculty & Research - Harvard Business School.
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First of all, the executive's personal investment opportunity set is expanded to include risky assets as well as the risk-free asset. Risky investments are not considered in previous studies. Furthermore, the value of non-traded stock options is determined within a standard principal-agent model with information asymmetry.

The principal shareholder optimally selects a compensation contract in order to induce the desired level of effort from the agent executive , fully aware that the executive take action to maximize his own expected utility. Unlike previous research, option value determined this way is consistent with the executive's utility maximization behavior.

In addition, the optimal contract between the shareholder and the executive is a combination of incentive pay and cash pay. However, option is the optimal form of incentive pay only if the executive has a relatively low degree of risk aversionand effort aversion. Restriced stock is optimal for other executives. The optimal incentive pay cannot always overcome the executive's risk and effort aversion because the optimal proportion of incentive pay is actully negatively related to the executive's degree of risk aversion and effort aversion.

The shareholder is always better off if the executive is less risk averse and effort averse. These findings are robust with respect to various parameters concerning option exercise price, stock volatility, outside investment opportinities, and the executive's initial wealth, utility function and disutility of effort. This paper allows different types of news to have different impacts on returns and expected volatility. The conditional variance is a mixture of smoothly changing augmented GARCH and discontinuous jump components.

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This mixture captures occasional large changes in price, due to news events such as earnings surprises, as well as smoother changes in prices which may be due to liquidity trading or strategic trading as information disseminates. The parameterization allows asymmetric effects from good and bad news and asymmetric feedback from previous jump innovations to future volatility.

A heterogeneous Poisson process governs the likelihood of jumps and is summarized by a time-varying conditional intensity parameter.

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Published in: Australian Journal of Management , Vol. Recent corporate scandals around the world have led many to single out executive stock options as one of the main culprits. More corporations are abandoning stock options and reverting to restricted stock. This paper argues that such a change is not entirely justifiable. We first provide a critical review of the pros and cons of executive stock options. We then compare option-based contracts with stock-based contracts using a simple principal-agent model with moral-hazard.

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In a general environment without restrictions on preferences or technologies, option-based contracts are shown to weakly dominate stock-based contracts. The weak dominance relation becomes strict if the manager is risk neutral. Numerical examples are provided to show that, even if the manager is risk averse, strict dominance is more likely the case. Acharya, V. Bebchuk, L. Brenner, B. Callaghan, S. Carpenter, J. Carter, M. Chance, D. M, Kumar, R. Chen, M. Chidambaran, N.