Power Options in Executive Compensation

Abstract

Many firms use options as a substantial portion of total executive compensation. Theoretical analysis points to the favorable incentive to work hard and perform that an option payoff gives. But linking compensation to the terminal stock price also introduces perverse incentives to do things that may hurt the firm but push the stock price up artificially just as the options reach maturity. One way to deal with this problem is to use an Asian structure that ties the payoff to the average stock price over the life of the contract. In this article, Bernard, Boyle, and Chen note that the value of option-based compensation to the executive and the cost to the firm of issuing the options are different, which raises the question of what payoff pattern is the cheapest way to provide a given level of utility to the executive. They propose the use of power options, whose payoff is based on the terminal stock price raised to some power greater than 1. They show that such a contract can be equally attractive to the executive as an Asian payoff but costs less. Then, in a simulation, they demonstrate that both types of options are much more efficient than plain-vanilla European calls, which cost more than twice as much but also have much higher volatility. The power option beats the Asian option in cost, in RMSE (root mean square error), and also in providing the desired incentives to the executive.

TOPICS: Options, quantitative methods