Stock Options and Managers' Incentives to Cheat
46 Pages Posted: 20 Jan 2005
Date Written: January 11, 2005
In this paper, we use a continuous-time contingent claims framework to study managers' incentives to cheat in the presence of equity-based compensation policies. When we consider a fully predictable legal process, we observe that managers will always have incentives to engage in illicit activities. The exercise of the option to cheat will be postponed if the corruption costs or if the manager's reputational loss increases. We further show that managers incentives to cheat are delayed and can even be eliminated when the legal settlement date is non-predictable. An important result is that managers will always cheat sooner with stock options than with a cash equivalent remuneration consisting of stocks. Finally, we propose a new remuneration package that consists of both long calls and short puts written on the firm's stocks in order to reduce managers incentives to cheat.
Keywords: Executive compensation, fraud, incentives, stock options
JEL Classification: G13, G30
Suggested Citation: Suggested Citation