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Power Options in Executive Compensation

Carole Bernard, Phelim Boyle and Jit Seng Chen
The Journal of Derivatives Spring 2016, 23 (3) 9-20; DOI: https://doi.org/10.3905/jod.2016.23.3.009
Carole Bernard
is a professor of finance in the Department of Accounting, Law and Finance at Grenoble Ecole de Management in Grenoble, France.
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  • For correspondence: carole.bernard@grenoble-em.com
Phelim Boyle
is a professor of finance at the School of Business and Economics, Wilfrid Laurier University in Waterloo, ON, Canada.
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  • For correspondence: pboyle@wlu.ca
Jit Seng Chen
is an actuary at GGY AXIS in Toronto, ON, Canada.
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  • For correspondence: jitseng.chen@ggy.com
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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

  • © 2016 Pageant Media Ltd
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The Journal of Derivatives: 23 (3)
The Journal of Derivatives
Vol. 23, Issue 3
Spring 2016
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Power Options in Executive Compensation
Carole Bernard, Phelim Boyle, Jit Seng Chen
The Journal of Derivatives Feb 2016, 23 (3) 9-20; DOI: 10.3905/jod.2016.23.3.009

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Power Options in Executive Compensation
Carole Bernard, Phelim Boyle, Jit Seng Chen
The Journal of Derivatives Feb 2016, 23 (3) 9-20; DOI: 10.3905/jod.2016.23.3.009
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  • Article
    • Abstract
    • FRAMEWORK
    • THE POWER EXECUTIVE OPTION
    • COMPARISON OF EXECUTIVE OPTIONS
    • CONCLUSIONS
    • APPENDIX A
    • APPENDIX B
    • APPENDIX C
    • ENDNOTES
    • REFERENCES
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