Managerial Control, Compensation, and Derivative Pricing
33 Pages Posted: 19 Sep 2006
Date Written: September 2006
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.
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