Stock Based Compensation: Firm-specific risk, Efficiency
and Incentives
Vicky Henderson
Abstract
This paper examines the efficiency of stock based
compensation by valuing stock and options from the executive's point of
view. Companies give compensation in the form of stock in order to align
incentives by providing a link between executive wealth and the stock price
performance of the company. However, it requires the executive to be exposed
to firm-specific risk, and thus hold a less than fully diversified
portfolio. Since firm-specific risk is not priced, this leads to the
executive placing less value on the options than their cost to the company,
given by their market value.
We propose a continuous time, utility maximisation model
to value the executive's com- pensation. We endogenise allocation of the
executive's non-option wealth as the executive may invest in the market
portfolio. Executives trade the market portfolio to adjust exposure to
market risk, but are subject to firm-specific risk for incentive purposes.
By distinguishing between these two types of risks, we are
able to examine the effect of stock volatility, firm-specific risk, market
risk and the correlation between the stock and the market, on the value to
the executive and incentives. We can prove that there is a negative
relationship between firm-specific risk and value, if volatility is fixed.
However, the value may increase or decrease with firm-specific risk if
market risk is fixed. The same ambiguous relationship is found if we
consider value as a function of volatility, so executives will not always
aim to increase the volatility of the stock price.
Just as the value of the compensation to the executive is
overstated in a Black Scholes model, the Black Scholes model also
exaggerates the incentives for the executive to increase the stock price. We
address the question of how the company can maximise incentives (for a given
cost) and show that if stock compensation replaces cash remuneration, it is
optimal to compensate with stock, rather than options.
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