Strike Prices of Options for Overconfident Executives
We explore via simulations the impacts of managerial overconfidence on the optimal strike prices of executive incentive options. Although it has been shown that, optimally, managerial incentive options should be awarded in-the-money, in practice most firms award them at-the-money. We show that the optimal strike prices of options granted to overconfident executive are directly related to their overconfidence level and that this bias brings the optimal strike prices closer to the institutionally prevalent at-the-money prices. Our results thus support the viability of the common practice of awarding managers with at-the-money incentive options. We also show that overoptimistic CEOs receive lower compensation than their realistic counterparts and that the stockholders benefit from their managers bias. The combined welfare of the firm’s stakeholders is, however, positively related to managerial overconfidence.
The Monte Carlo simulation procedure described in Sect. 55.3 uses a Mathematica program to find the optimal effort by managers and the optimal (for stockholders) contract parameters. An expanded discussion of the simulations, including the choice of the functional forms and the calibration of the parameters, is provided in Appendix 1.
KeywordsOverconfidence Managerial effort Incentive options Strike price Simulations Behavioral finance Executive compensation schemes Mathematica optimization Risk aversion Effort aversion
We thank Darius Palia, Orly Sade, and seminar participants at Rutgers University and the Universitat Pompeu Fabra for helpful comments and suggestions. The financial support of The Sanger Family Chair for Banking and Risk Management, The Galanter Fund, The Mordecai Zagagi Fund, the Whitcomb Center for Research in Financial Services, and The School of Accounting, the Hebrew University are gratefully acknowledged.
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