When Contracts Require Risk-Averse Executives to Hold Equity: Implications for Option Valuation and Relative Performance Evaluation

29 Pages Posted: 29 May 2001

See all articles by John E. Core

John E. Core

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Wayne R. Guay

University of Pennsylvania - Accounting Department

Date Written: May 2001

Abstract

A growing body of literature suggests that because an executive is risk-averse and undiversified, he values equity compensation and incentives at less than market value. This discount on valuation is driven by the assumption that the executive is constrained from rebalancing his portfolio following an equity grant, and as such, the payment of equity compensation permanently increases the risk and incentives borne by the executive. We relax this exogenous assumption, and assume that firms contract with their executives and agree upon a specified level of risk. Firms expect and require that executives rebalance their portfolios when equity risk rises above or falls below the contracted level. Under these assumptions, we show that the executive does not discount the value of equity compensation or changes in the value of his equity portfolio.

The notion that firms write contracts that require executives to hold equity also suggests that executive contracts are more consistent with relative performance evaluation than has been found in prior empirical research. Specifically, this type of contract requires executives to reduce the fraction of their total wealth held in a well-diversified portfolio and to increase their investment in firm equity.

Keywords: Stock options, Option valuation, Contracting, Equity incentives, Managerial compensation, Managerial ownership

JEL Classification: G32, J33, J41, M41

Suggested Citation

Core, John E. and Guay, Wayne R., When Contracts Require Risk-Averse Executives to Hold Equity: Implications for Option Valuation and Relative Performance Evaluation (May 2001). Available at SSRN: https://ssrn.com/abstract=271123 or http://dx.doi.org/10.2139/ssrn.271123

John E. Core (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02138
United States

Wayne R. Guay

University of Pennsylvania - Accounting Department ( email )

3641 Locust Walk
1329 Steinberg-Dietrich Hall
Philadelphia, PA 19104-6365
United States
215-898-7775 (Phone)
215-573-2054 (Fax)

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