Executive options with inflated equity prices

Abstract

Purpose

The purpose of this paper is to solve the optimal managerial compensation problem when shareholders are either naïvely optimistic or rational.

Design/methodology/approach

The paper uses applied game theory to derive the optimal CEO compensation package with over optimistic shareholders.

Findings

The results suggest that boards of directors should decrease option grants to CEOs when equity is likely to be irrationally overvalued at the date when the CEO's options vest.

Research limitations/implications

The implications of the model are consistent with the available empirical evidence. In addition, the model generates new testable predictions about managerial stock price manipulation, the number of options granted, and the magnitude of the options’ strike prices that have not yet been formally tested.

Originality/value

This is the only paper to derive closed-form solutions to optimal CEO compensation when shareholders are naïvely optimistic.

Citation

Wilson, L. and Wendy Wu, Y. (2014), "Executive options with inflated equity prices", International Journal of Managerial Finance, Vol. 10 No. 3, pp. 266-292. https://doi.org/10.1108/IJMF-03-2011-0019