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The Subjective Valuation of Indexed Stock Options and Their Incentive Effects

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  • A. Louis Calvet
  • Abdul H. Rahman

Abstract

We analyze the potential role of indexed stock options in future pay‐for‐performance executive compensation contracts. We present a unified framework for index‐linked stock options, discuss their incentive effects, argue that indexation schemes based on the capital‐asset pricing model (CAPM) are the most suitable for executive compensation, and derive a subjective pricing model for the class of CAPM‐based indexed stock options. Contrary to earlier work, executives would not be motivated to take on investment projects with high idiosyncratic risk once their lack of wealth diversification and degree of risk aversion are factored into the analysis.

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  • A. Louis Calvet & Abdul H. Rahman, 2006. "The Subjective Valuation of Indexed Stock Options and Their Incentive Effects," The Financial Review, Eastern Finance Association, vol. 41(2), pages 205-227, May.
    • Handle: RePEc:bla:finrev:v:41:y:2006:i:2:p:205-227
    DOI: 10.1111/j.1540-6288.2006.00139.x
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    Cited by:

    1. Carmona, Julio & León, Angel & Vaello-Sebastià, Antoni, 2011. "Pricing executive stock options under employment shocks," Journal of Economic Dynamics and Control, Elsevier, vol. 35(1), pages 97-114, January.
    2. León, Angel & Vaello-Sebastià, Antoni, 2010. "A simulation-based algorithm for American executive stock option valuation," Finance Research Letters, Elsevier, vol. 7(1), pages 14-23, March.
    3. Campbell, T. Colin & Thompson, Mary Elizabeth, 2015. "Why are CEOs paid for good luck? An empirical comparison of explanations for pay-for-luck asymmetry," Journal of Corporate Finance, Elsevier, vol. 35(C), pages 247-264.
    4. João Paulo Vieito & António Cerqueira & Elísio Brandão & Walayet A. Khan, 2009. "Executive Compensation: the Finance Perspective," Portuguese Journal of Management Studies, ISEG, Universidade de Lisboa, vol. 0(1), pages 3-32.
    5. Philip Brown & Alex Szimayer, 2008. "Valuing executive stock options: performance hurdles, early exercise and stochastic volatility," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 48(3), pages 363-389, September.
    6. Chen, Fang & Jia, Jianjun & Lin, Yuen & Xiang, George, 2022. "Should managers be incentivized with stock or options? Evidence from China," Pacific-Basin Finance Journal, Elsevier, vol. 75(C).
    7. Tang, Chun-Hua, 2016. "Impacts of future compensation on the incentive effects of existing executive stock options," International Review of Economics & Finance, Elsevier, vol. 45(C), pages 273-285.

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