Options in Compensation: Promises and Pitfalls

32 Pages Posted: 6 Jun 2006 Last revised: 31 Jan 2014

See all articles by Christian Riis Flor

Christian Riis Flor

University of Southern Denmark

Hans Frimor

University of Southern Denmark - Department of Business and Economics; Aarhus University

Claus Munk

Copenhagen Business School

Multiple version iconThere are 2 versions of this paper

Date Written: January 31, 2014

Abstract

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

Flor, Christian Riis and Frimor, Hans and Munk, Claus, Options in Compensation: Promises and Pitfalls (January 31, 2014). Forthcoming, Journal of Accounting Research. Available at SSRN: https://ssrn.com/abstract=906107 or http://dx.doi.org/10.2139/ssrn.906107

Christian Riis Flor

University of Southern Denmark ( email )

Campusvej 55
Odense DK-5230
Denmark
+45 6550 3384 (Phone)
+45 6593 0726 (Fax)

Hans Frimor (Contact Author)

University of Southern Denmark - Department of Business and Economics ( email )

DK-5230 Odense
Denmark

Aarhus University ( email )

Department of Economics and Business
Bartholins Allé 10
Aarhus DK-8000
Denmark
+45 8942 2141 (Phone)

Claus Munk

Copenhagen Business School ( email )

Department of Finance
Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

HOME PAGE: http://sites.google.com/view/clausmunk/home

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