Managerial Responses to Incentives: Control of Firm Risk, Derivative Pricing Implications, and Outside Wealth Management

38 Pages Posted: 17 Mar 2008

See all articles by James E. Hodder

James E. Hodder

Wisconsin School of Business

Jens Carsten Jackwerth

University of Konstanz - Department of Economics

Date Written: February 25, 2008

Abstract

We model a firm's value process controlled by a manager maximizing expected utility from restricted shares and employee stock options. The manager also dynamically controls allocation of his outside wealth. We explore interactions between those controls as he partially hedges his exposure to firm risk. Conditioning on his optimal behavior, control of firm risk increases the expected time to exercise for his employee stock options. It also reduces the percentage gap between his certainty equivalent and the firm's fair value for his compensation, but that gap remains substantial. Managerial control also causes traded options to exhibit an implied volatility smile.

Keywords: Dynamic Control of Firm Value Process, Managerial Incentives, Derivative Pricing Implications, External Wealth management

JEL Classification: G34, C61, G13, G11

Suggested Citation

Hodder, James Ernest and Jackwerth, Jens Carsten, Managerial Responses to Incentives: Control of Firm Risk, Derivative Pricing Implications, and Outside Wealth Management (February 25, 2008). Available at SSRN: https://ssrn.com/abstract=1106482 or http://dx.doi.org/10.2139/ssrn.1106482

James Ernest Hodder (Contact Author)

Wisconsin School of Business ( email )

975 University Avenue
Madison, WI 53706
United States
608-262-8774 (Phone)
608-263-0477 (Fax)

Jens Carsten Jackwerth

University of Konstanz - Department of Economics ( email )

Universitaetsstr. 10
Konstanz, 78457
Germany
+497531882196 (Phone)
+497531883120 (Fax)

HOME PAGE: http://cms.uni-konstanz.de/wiwi/jackwerth/

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