Table of Contents (Jump to)

1 Introduction

2 Fixed Price Options versus Indexed Options

3 Case for Indexed Options

3.1 Compensation for Relative rather than Absolute Performance

3.2 Protection of Managers during Market Downswings

3.3 Reduced Expected Costs

4 Case against Indexed Options

4.1 Unpredictability

4.2 Difficulty in Controlling Compensations

4.3 Larger Deadweight Costs.

4.4 Tax Treatment

4.5 Reluctance of Managers

5 Reasons for Choosing Alternatives of Indexed Options

5.1 Requirements of Firms

5.2 Sensitivity of Payoff

6 Empirical Evidence

7 Conclusion

8 References

1 Introduction

The principal-agent problem has long been a matter of discussion within organisational institutions. As a matter of fact, the owners of a limited company normally elect a Board of Directors to control the business’s resources on their behalf. However, conflict arises among these managers and shareholders due to their different objectives.

As owners, shareholders would want to maximise profits while managers may want to maximise sales, build empire buildings and enjoy perks. To align the interests of both stakeholders therefore, compensation of managers should be linked with the firm’s performance. One way to do this is the introduction of options: fixed price options and indexed options.

Basically, an option is a financial derivative representing a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security.

Fixed price options and indexed options differ significantly from each other. For the purpose of this assignment, we will discuss how indexed options provide a better case compared to fixed price options.

2 Fixed Price Options versus Indexed Options

Fixed price options whose exercise price is already agreed upon and will remain the same until expiration date. The option exercise price is usually set equal to the stock price at grant. When an executive is given a fixed price option as a means compensation, two situations can arise. If the share price rises above the exercise price, the executive gains. On the other hand, the executive receive absolutely nothing if there is a decrease in share price

In contrast, an indexed option is a stock option whose exercise price is connected to a benchmark index, which may be a specific sector index or a broad market index. Indexed price options have unknown selling price when contract is being made, and the final price of the option depends on market status on the expiration date. A change in the absolute value of the share will have no effect unless thecompanyoutperformssomestatedindex suchastheS&P500 or a group of peers. Then only, the optionwillbeexercised.