Should Executive Stock Options Be Abandoned?

Abstract

Recent corporate scandals around the world have led many to single out executive stock options as one of the main culprits. More corporations are abandoning stock options and reverting to restricted stock. This paper argues that such a change is unwarranted and unfortunate. Using a simple, but general principal-agent model with moral-hazard, this paper compares option-based contracts with stock-based contracts. In a general environment without restrictions on preferences or technologies, option-based contracts are shown to weakly dominate stock-based contracts. The weak dominance relation becomes strict if the manager is risk neutral.

Keywords: Executive stock options, restricted stock, optimal contract

JEL Classification: D82, G32, J33