BFS 2002

Contributed Talk

Executive Stock Options with Effort Disutility and Choice of Volatility

Abel Cadenillas, Jaksa Cvitanic, Fernando Zapatero

We consider the problem of an executive that receives call options as compensation in a dynamic setting. He can influence the stock price return with his effort. In addition, he determines the level of volatility of the stock through the choice of projects. The executive is risk-averse and experiences disutility from the effort. In this framework, we introduce the problem of the company that wants to maximize the final expected value of the price of the stock minus the cost of the compensation package. The company has to design a compensation package such that the executive reaches the minimum level of utility or opportunity cost (individual rationality constraint). We characterize the optimal strike price the company should choose, and compute it numerically for the logarithmic case.