Lionel Martellini, Branko Urosevic: Executive compensation packages are often valued in an inconsistent manner: while employee stock options (ESOs) are typically valued ex-ante, i.e. before uncertainties are resolved, cash bonuses are valued ex-post, i.e. by discounting the realised cash grants.
Professor of Finance, EDHEC Graduate School of Business
Assistant Professor of Finance, CREFC, Department of Economics and Business,Universitat Pompeu Fabra
Such a lack of consistency can, potentially, distort empirical results. A related, yet mostly overlooked, problem is that when ex-post valuation is used, pay-performance measures can not be well defined. Consistent use of ex-ante valuation for all components of a compensation package would simultaneously resolve both of these problems and provide a natural framework for the analysis of agency problems. In this paper, we perform ex-ante valuation of cash bonus contracts as if the executive's performance were measured by the company stock price, demonstrate how the shape of the bonus contract influences the executive's attitude toward risk, and study the pay-performance sensitivity of such contracts. We commence by demonstrating that a typical executive bonus contract with a linear incentive zone has a pay-off structure equivalent to a portfolio of standard and binary European call options so that the ex-ante contract value is given by the linear combination of Black and Scholes call and binary call prices, with the strike prices at the boundary points of the incentive zone. Assuming that a risk neutral executive can choose the level of stock price volatility by selecting a set of projects at origination, we show that bonus contract terms can dramatically affect the executive's risk taking behaviour and payperformance incentives. Our results are extended to bonus contracts with non-linear incentive zones, and performance share contracts with vesting risk.
|Research Cluster :||Finance|