Ironing Out the Kinks in Executive Compensation: Linking Incentive Pay to Average Stock Prices

66 Pages Posted: 16 Sep 2012  

Yisong S. Tian

York University - Schulich School of Business

Date Written: August 30, 2012

Abstract

Traditional stock option grant is the most common form of incentive pay in executive compensation. Applying a principal-agent analysis, we find this common practice suboptimal and firms are better off linking incentive pay to average stock prices. Among other benefits, averaging reduces volatility by about 42%, making the incentive pay more attractive to risk-averse executives. Holding the cost of the option grant to the firm constant, Asian stock options are more cost effective than traditional stock options and provide stronger incentives to increase stock price. More importantly, the improvement is achieved with little impact on the option grant’s risk incentives (after adjusting for option cost). Finally, averaging also improves the value and incentive effects of indexed stock options.

Keywords: Executive compensation, Optimal contracting, Executive stock options, Cost effectiveness, Incentive effects, Asian options, Indexed options

JEL Classification: G13, G30, J33, M52

Suggested Citation

Tian, Yisong S., Ironing Out the Kinks in Executive Compensation: Linking Incentive Pay to Average Stock Prices (August 30, 2012). Journal of Banking and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2146997

Yisong Sam Tian (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100, ext 77943 (Phone)
416-736-5687 (Fax)

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