When Efficient Contracts Require Risk-Averse Executives to Hold Equity: Implications for Option Valuation, for Relative Performance Evaluation, and for the Corporate Governance Debate
39 Pages Posted: 15 Aug 2003
Date Written: July 2003
Abstract
A growing body of literature suggests that because risk-averse executives are undiversified, they value equity compensation at significantly less (over 30%) than market value. This valuation discount is driven by the assumptions that the firm ignores existing incentives when it grants equity, and does not allow executives to buy or sell firm stock for a multi-year period following a grant. We instead assume that firms contract efficiently, which means that contracts require executives to hold precise amounts of incentives (e.g., Holmstrom, 1979). Under this efficient contracting assumption, we show that executive discounts to the value of equity compensation are small (less than 6%). Finally, when firms write efficient contracts over executive wealth, these contracts are consistent with relative performance evaluation: they require executives to increase their exposure to firm-specific risk by reducing (increasing) the amount of wealth they hold in diversified portfolios (firm equity).
Keywords: stock options, option valuation, contracting, equity incentives, managerial compensation, managerial ownership
JEL Classification: G32, J33, J41, M41
Suggested Citation: Suggested Citation
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