Options in Compensation: Promises and Pitfalls
32 Pages Posted: 6 Jun 2006 Last revised: 31 Jan 2014
Date Written: January 31, 2014
We derive the optimal compensation contract in a principal-agent setting in which outcome is used to provide incentives for both effort and risky investments. To motivate investment, optimal compensation entails rewards for high as well as low outcomes, and it is increasing at the mean outcome to motivate effort. If rewarding low outcomes is infeasible, compensation consisting of stocks and options is a near-efficient means of overcoming the manager's induced aversion against undertaking risky investments, whereas stock compensation is not. However, stock plus option compensation may induce excessively risky investments, and capping pay can be important in curbing such behavior.
Keywords: Induced moral hazard, incentives for investment, option-based compensation, excessive risk-taking, capped compensation, regulation.
JEL Classification: D82, G31, M48, M52
Suggested Citation: Suggested Citation