Stock Options and Chief Executive Officer Compensation

Abstract

Although stock options are commonly observed in chief executive officer (CEO) compensation contracts, there is theoretical controversy about whether stock options are part of the optimal contract. Using a sample of Fortune 500 companies, we solve an agency model calibrated to the company-specific data and we find that stock options are almost always part of the optimal contract. This result is robust to alternative assumptions about the level of CEO risk-aversion and the disutility associated with their effort. In a supplementary analysis, we solve for the optimal contract when there are no restrictions on the contract space. We find that the optimal contract (which is characterized as a state-contingent payoff to the CEO) typically has option-like features over the most probable range of outcomes.

Paper published as: "Endogenous Selection and Moral Hazard in Compensation Contracts" in Operations Research, Linthicum 58 (July/August 2010): 1090-1106.

Keywords: Stock Options, Incentives, Agency Model

JEL Classification: C61, D82, D86, J33, J41