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Optimal Incentive Contracts for Loss‐Averse Managers: Stock Options versus Restricted Stock Grants
Author(s) -
Dodonova Anna,
Khoroshilov Yuri
Publication year - 2006
Publication title -
financial review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.621
H-Index - 47
eISSN - 1540-6288
pISSN - 0732-8516
DOI - 10.1111/j.1540-6288.2006.00153.x
Subject(s) - stock options , incentive , non qualified stock option , stock (firearms) , cash flow , executive compensation , volatility (finance) , restricted stock , economics , business , loss aversion , cash , microeconomics , financial economics , monetary economics , actuarial science , finance , stock market , mechanical engineering , paleontology , horse , engineering , biology
This paper provides an explanation for the widespread use of stock option grants in executive compensation. It shows that the optimal incentive contract for loss‐averse managers must contain a substantial portion of stock options even when it should consist exclusively of stock grants for “classical” risk‐averse managers. The paper also provides an explanation for the drastic increase in the risk‐adjusted level of CEO compensations over the past two decades and argues that more option‐based compensation should be used in firms with higher cash flow volatility and in industries with a higher degree of heterogeneity among firms.