Does Option Compensation Increase Managerial Risk Appetite?

Authors

  • Jennifer N. Carpenter

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    • Department of Finance, Stern School of Business, New York University. I thank Franklin Allen, Suleyman Basak, Philip Dybvig, Edwin Elton, Sanford Grossman, Bruce Grundy, Kose John, Ioannis Karatzas, Richard Kihlstrom, Anthony Lynch, René Stulz (the editor), David Yermack, and an anonymous referee for helpful comments and suggestions.

Abstract

This paper solves the dynamic investment problem of a risk averse manager compensated with a call option on the assets he controls. Under the manager's optimal policy, the option ends up either deep in or deep out of the money. As the asset value goes to zero, volatility goes to infinity. However, the option compensation does not strictly lead to greater risk seeking. Sometimes, the manager's optimal volatility is less with the option than it would be if he were trading his own account. Furthermore, giving the manager more options causes him to reduce volatility.

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