Stocks or Options? Moral Hazard, Firm Viability, and the Design of Compensation Contracts

We consider the choice between stocks and options to provide effort incentives to a risk-averse manager. We show that stocks can dominate options as a means of motivation only if nonviability risk is substantial, as in financially distressed firms or start-ups. Options dominate stocks for other firm...

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Bibliographic Details
Published in:The Review of financial studies 2008-01, Vol.21 (1), p.451-482
Main Authors: Kadan, Ohad, Swinkels, Jeroen M.
Format: Article
Language:English
Subjects:
Bank stocks
Bankruptcy
Business structures
Compensation
Economic theory
Employment contracts
Executive compensation
Financial engineering
Financial incentives
Financial management
Financial risk
Incentives
Management science
Moral hazard
Motivation
Options on stocks
Price levels
Restricted stock
Risk
Risk aversion
Risk management
Senior management
Startups
Stock options
Stock prices
Strike prices
Studies
Wages & salaries
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Summary:We consider the choice between stocks and options to provide effort incentives to a risk-averse manager. We show that stocks can dominate options as a means of motivation only if nonviability risk is substantial, as in financially distressed firms or start-ups. Options dominate stocks for other firms. These results hold regardless of the existing portfolio of the manager. We provide empirical evidence that higher bankruptcy risk is indeed correlated with more use of stock.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhm077