Optimal Payoff Schemes for Managers (Asymmetric Information Case)

Abstract

This paper analyzes which stock option scheme best aligns the interests of a firm’s manager and shareholders when both are risk-averse. We consider granting to the manager one of the following four options: European, Parisian, Asian and American options. This paper extends Chen and Pelger (2012) to the case of information asymmetry, i.e. when the shareholders are uncertain about the Sharpe ratio or risk aversion of the managers. We express the expected utility as a function of a local risk measure to select the option scheme which either leads to the highest welfare of the shareholder or to the most "robust" result (in the sense of least sensitive to information asymmetry and best protecting uninformed shareholders). Under information asymmetry, the American option scheme seems to exhibit the smallest utility loss, while the Asian option scheme performs best in a worst-case analysis.

Keywords: Different Executive Stock Options, Asian, American and Parisian Options, Welfare Analysis

JEL Classification: G12, G13, G32, G34