Options, Option Repricing and Severance Packages in Managerial Compensation: Their Effects on Corporate Risk
35 Pages Posted: 6 Apr 2003
Date Written: December 2002
While stock options are commonly used in managerial compensation to provide desirable incentives, their adverse effects have not been widely appreciated. We show that a call-type contract creates incentives to distort the choice of investment risk. Relative to the risk level that maximizes firm value, a call option contract can induce too much or too little corporate risk-taking, depending on managerial risk aversion and the underlying investment technology. We show that including additional compensation features of option repricing and/or severance packages has desirable countervailing effects on managerial choice of corporate risk policies. We argue that lookback call options are analogous to the observed practice of option repricing, and put options are analogous to severance packages. Such complex option-like features in managerial contracts can induce risk policies that increase shareholder wealth.
Keywords: Managerial compensation, option repricing and severance packages, managerial incentives
JEL Classification: G3
Suggested Citation: Suggested Citation