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Principal agent problems under loss aversion: an application to executive stock options

de Meza, David and Webb, David C. (2004) Principal agent problems under loss aversion: an application to executive stock options. Discussion paper, 478. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Identification Number: 478

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.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2004 The Authors
Subjects: H Social Sciences > HB Economic Theory
JEL classification: F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance
F - International Economics > F3 - International Finance
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Date Deposited: 30 Jul 2009 15:14
Last Modified: 27 Feb 2014 15:35
URI: http://eprints.lse.ac.uk/id/eprint/24676

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