Accepted by Haresh Sapra. We appreciate comments from an anonymous referee, Anil Arya, Peter Ove Christensen, Joel Demski, John Fellingham, Steven Huddart, Brian Mittendorf, and Richard Young as well as participants at the 2011 Chicago-Minnesota Accounting Theory Conference.
Options in Compensation: Promises and Pitfalls
Article first published online: 6 MAR 2014
Copyright ©, University of Chicago on behalf of the Accounting Research Center, 2014
Journal of Accounting Research
Volume 52, Issue 3, pages 703–732, June 2014
How to Cite
FLOR, C. R., FRIMOR, H. and MUNK, C. (2014), Options in Compensation: Promises and Pitfalls. Journal of Accounting Research, 52: 703–732. doi: 10.1111/1475-679X.12049
- Issue published online: 28 APR 2014
- Article first published online: 6 MAR 2014
- Accepted manuscript online: 6 FEB 2014 08:20AM EST
- Manuscript Accepted: 16 DEC 2013
- Manuscript Received: 2 NOV 2012
We derive the optimal compensation contract in a principal–agent setting in which outcome is used to provide incentives for both effort and risky investments. To motivate investment, optimal compensation entails rewards for high as well as low outcomes, and it is increasing at the mean outcome to motivate effort. If rewarding low outcomes is infeasible, compensation consisting of stocks and options is a near-efficient means of overcoming the manager's induced aversion to undertaking risky investments, whereas stock compensation is not. However, stock plus option compensation may induce excessively risky investments, and capping pay can be important in curbing such behavior.