Advertisement

Review of Managerial Science

, Volume 8, Issue 4, pp 437–464 | Cite as

Optimal stock option schemes for managers

  • An Chen
  • Markus Pelger
Original Paper

Abstract

This paper analyzes which stock option scheme best aligns the interests of a firm’s manager and shareholders when both are risk-averse. We consider granting to the manager a basic fixed salary and one of the following four options: European, Parisian, Asian and American options. Choosing the strike of the options optimally, the shareholders can mostly implement a first best solution with all payoff schemes. The American option scheme best aligns the interests of the manager and the shareholders in the most common case in which the strike price equals the grant-date fair market value.

Keywords

Different executive stock options Asian, American and Parisian options Welfare analysis 

JEL Classification

G12 G13 G32 

References

  1. Anderluh J, Van der Weide H, (2004) Parisian options—the implied barrier concept. In: Bubak M, van Albada GD, Sloot PMA, Dongarra JJ (eds) Computational science—ICCS 2004, lecture notes in computer science. Springer, pp 851–858Google Scholar
  2. Barone-Adesi G, Whaley RE (1987) Efficient analytic approximation of American option values. J Financ 42(2):301–320Google Scholar
  3. Bettis JC, Bizjak JM, Lemmon ML (2005) Exercise behavior, valuation, and the incentive effects of employee stock options. J Financ Econ 76:445–470CrossRefGoogle Scholar
  4. Borch K (1962) Equilibrium in a reinsurance market. Econometrica 30:424–444CrossRefGoogle Scholar
  5. Broadie M, Glasserman P (1997a) Pricing American-style securities using simulation. J Econ Dyn Control 21:1323–1352CrossRefGoogle Scholar
  6. Broadie M, Glasserman P (1997b) A stochastic mesh method for pricing high-dimensional American options. Working paper, Columbia Business School, Columbia University, New YorkGoogle Scholar
  7. Cadenillas A, Cvitanic J, Zapatero F (2004) Leverage decision and manager compensation with choice of effort and volatility. J Financ Econ 73:71–92CrossRefGoogle Scholar
  8. Carpenter J (2000) Does option compensation increase managerial risk appetite? J Financ 55:2311–2331CrossRefGoogle Scholar
  9. Chen A, Pelger M, Sandmann K (2013) New performance-vested stock option schemes. Appl Financ Econ 23(8):709–727CrossRefGoogle Scholar
  10. Cvitanić J, Zhang J (2007) Optimal compensation with adverse selection and dynamic actions. Math Financ Econ 1:21–55CrossRefGoogle Scholar
  11. Cvitanić J, Zhang J (2013) Contract theory in continuous time models. Springer, BerlinCrossRefGoogle Scholar
  12. Datta S, Iskanda-Datta M, Raman K (2001) Executive compensation and corporate acquisition decisions. J Financ 56:2299–2336CrossRefGoogle Scholar
  13. Defusco RA, Johnson RR, Zorn TS (1990) The effect of executive stock option plans on stockholders and bondholders. J Financ 45:617–627CrossRefGoogle Scholar
  14. Dybvig PH, Loewenstein M (2003) Employee reload options: pricing, hedging, and optimal exercise. Rev Financ Stud 16:145–171CrossRefGoogle Scholar
  15. Feltham G, Wu M (2001) Incentive efficiency of stock versus options. Rev Account Stud 6:7–28CrossRefGoogle Scholar
  16. Garvey GT, Mawani A (2007) Executive stock options and dynamic risk-taking incentives. Manag Financ 33:281–288Google Scholar
  17. Gomez-Mejia L, Wiseman RM (1997) Reframing executive compensation: an assessment and outlook. J Manag 23(3):291–374Google Scholar
  18. Hall BJ, Murphy KJ (2000) Optimal exercise prices for executive stock options. Am Econ Rev 90(2), Papers and Proceedings of the one hundred twelfth annual meeting of the American economic association (May 2000), pp 209–214Google Scholar
  19. Hall BJ, Murphy KJ (2002) Stock options for undiversified executives. J Account Econ 33:3–42CrossRefGoogle Scholar
  20. Hall BJ, Murphy KJ (2003) The trouble with stock options. J Econ Perspect 17:49–70CrossRefGoogle Scholar
  21. He Z, Wei B, Yu J (2011) Permanent risk and dynamic incentives. Working paperGoogle Scholar
  22. Hemmer T, Kim O, Verrecchia RE (2000) Introducing convexity into optimal compensation contracts. J Account Econ 28:307–327CrossRefGoogle Scholar
  23. Holmstöm B, Milgrom P (1987) Aggregation and linearity in the provision of intertemporal incentives. Econometrica 55:303–328CrossRefGoogle Scholar
  24. Jin L (2002) CEO compensation, diversification, and incentives. J Financ Econ 66:29–63CrossRefGoogle Scholar
  25. Johnson SA, Tian YS (2000) The value and incentive effects of nontraditional executive stock option plans. J Financ Econ 57:3–34CrossRefGoogle Scholar
  26. Ju N, Wan X (2010) Optimal compensation and pay-performance sensitivity in a continuous-time principal-agent model. Working paper, HKUSTGoogle Scholar
  27. Kadan O, Swinkels JM (2008) Stocks or options? Moral hazard, firm viability, and the design of compensation contracts. Rev Financ Stud 21(1):451–482CrossRefGoogle Scholar
  28. Kanniainen J (2010) Risk incentives of executive stock options for undiversified managers. Rev Manag Sci 4:7–32CrossRefGoogle Scholar
  29. Lambert RA, Lanen WN, Larcker DF (1989) Executive stock option plans and corporate dividend policy. J Financ Quant Anal 24:409–425CrossRefGoogle Scholar
  30. Longstaff F, Schwartz E (2001) Valuing American options by simulation: a simple least-squares approach. Rev Financ Stud 14:113–148CrossRefGoogle Scholar
  31. Meulbroek LK (2001) The efficiency of equity-linked compensation: understanding the full cost of awarding executive stock options. Financ Manag 30:5–44CrossRefGoogle Scholar
  32. Milgrom P, Roberts J (1992) Economics, organization and management. Prentice-Hall, LondonGoogle Scholar
  33. Murphy (1999) Executive compensation, chapter 38. In: Handbook of labor economics, vol 3, Part B. pp 2485–2563Google Scholar
  34. Rajgopal S, Shevlin S (2002) Empirical evidence on the relation between stock option compensation and risk taking. J Account Econ 2(33):145–171CrossRefGoogle Scholar
  35. Ross S (2004) Compensation, incentives and the duality of risk aversion and riskiness. J Financ 59(1):207–225Google Scholar
  36. Sharpe WF (1970) Portfolio theory and capital markets. McGraw-Hill, New YorkGoogle Scholar
  37. Sicar R, Xiong W (2007) A general framework for evaluating executive stock options. J Econ Dyn Control 31:2317–2349CrossRefGoogle Scholar
  38. Tian YS (2004) Too much of a good incentive? The case of executive stock options. J Banking Financ 28:1225–1245CrossRefGoogle Scholar
  39. Tsitsiklis J, Van Roy B (1999) Optimal stopping of Markov processes: Hilbert space theory, approximation algorithms, and an application to pricing financial derivatives. IEEE Trans Autom Control 44:1840–1851CrossRefGoogle Scholar
  40. Tsitsiklis J, Van Roy B (2000) Regression methods for pricing complex American-style options. Working paper. Laboratory for Information and Decision Systems, MIT, CambridgeGoogle Scholar

Copyright information

© Springer-Verlag Berlin Heidelberg 2013

Authors and Affiliations

  1. 1.Netspar and Faculty of Mathematics and EconomicsUniversity of UlmUlmGermany
  2. 2.Department of EconomicsUniversity of California, BerkeleyBerkeleyUSA

Personalised recommendations