Optimal Contracting, Incentive Effects and the Valuation of Executive Stock Options
58 Pages Posted: 19 May 2001
Date Written: April 30, 2001
In this paper, I examine the optimal contracting problem between a firm and its chief executive officer in a principal-agent framework with information asymmetry. The firm (principal) selects the size and composition of the agent's (executive's) compensation in order to maximize firm value. Given a compensation contract, the risk-averse and effort-averse agent in turn maximizes his own expected utility by optimizing his effort at the firm and the allocation of his outside investments. Using parameters consistent with average CEO pay of S&P 500 companies, I find that market performance (stock price) based incentive pay represents an important part (14 to 100%) of the optimal compensation contract between the firm and its executive. However, the optimal contract includes stock option grants only if the executive is at most modestly risk averse (with coefficient of relative risk aversion < 2). When the executive is more risk averse, restricted stock is the preferred choice of incentive pay. In addition, incentive pay cannot overcome the agency problem if the executive is highly risk averse and effort averse, and the potential loss in firm value can be as high as 40% if the wrong type of executive is hired. Furthermore, the value of a non-traded stock option depends largely on the executive's degree of risk aversion and effort aversion, his investment opportunities, and the compensation package. This value can deviate significantly from the Black-Scholes/Merton price of the option. These findings are robust with respect to various parameters concerning option exercise price, stock return volatility, outside investment opportunities, the executive's initial wealth, and utility function.
Keywords: Optimal contracting, principal-agent theory, executive compensation, incentive effects, executive stock options, certainty equivalent value
JEL Classification: J33, G13
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