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Principal Agent Problems Under Loss Aversion: An Application to Executive Stock Options

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  • David De Meza
  • David C Webb

Abstract

Executive stock options reward success but do not penalise failure. In contrast, the standard principalagent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, the use of carrots but not sticks is a feature of an optimal compensation contract. Low risk aversion and high loss aversion is particularly propitious to the use of options. Moreover, loss aversion on the part of executives explains the award of at the money options rather than discounted stock or bonus related pay. Other features of stock option grants are also explained, such as resetting or reloading with an exercise price equal to the current stock price.

Suggested Citation

  • David De Meza & David C Webb, 2004. "Principal Agent Problems Under Loss Aversion: An Application to Executive Stock Options," FMG Discussion Papers dp478, Financial Markets Group.
    • Handle: RePEc:fmg:fmgdps:dp478
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    References listed on IDEAS

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    JEL classification:

    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • F3 - International Economics - - International Finance

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