Managerial Control, Compensation, and Derivative Pricing

33 Pages Posted: 19 Sep 2006

See all articles by James E. Hodder

James E. Hodder

Wisconsin School of Business

Jens Carsten Jackwerth

University of Konstanz - Department of Economics

Date Written: September 2006

Abstract

We model a firm's value process controlled by a manager maximizing expected utility from restricted shares and employee stock options. Conditioning on his optimal behavior, we value derivatives on that controlled process. Control results in a longer expected time to exercise for the manager's stock options. It also reduces the percentage gap between his certainty equivalent and the firm's fair value for his compensation, but that gap remains substantial. Employees without control capabilities will generally face larger gaps; and for such employees, option compensation can be very inefficient. Managerial control also causes traded options to exhibit an implied volatility smile.

Suggested Citation

Hodder, James Ernest and Jackwerth, Jens Carsten, Managerial Control, Compensation, and Derivative Pricing (September 2006). Available at SSRN: https://ssrn.com/abstract=931097 or http://dx.doi.org/10.2139/ssrn.931097

James Ernest Hodder

Wisconsin School of Business ( email )

975 University Avenue
Madison, WI 53706
United States
608-262-8774 (Phone)
608-263-0477 (Fax)

Jens Carsten Jackwerth (Contact Author)

University of Konstanz - Department of Economics ( email )

Universitaetsstr. 10
Konstanz, 78457
Germany
+497531882196 (Phone)
+497531883120 (Fax)

HOME PAGE: http://cms.uni-konstanz.de/wiwi/jackwerth/

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