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RFS Advance Access originally published online on November 20, 2007
Review of Financial Studies 2008 21(1):451-482; doi:10.1093/rfs/hhm077
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: journals.permissions@oxfordjournals.org

Stocks or Options? Moral Hazard, Firm Viability, and the Design of Compensation Contracts

Ohad Kadan and Jeroen M. Swinkels
Washington University in St. Louis

Address correspondence to Jeroen M. Swinkels, John M. Olin School of Business, Washington University, 1 Brookings Drive, S. Louis, MO 63130-4899; telephone: (314) 935-6307, email: swinkels{at}wustl.edu.


  Abstract

We consider the choice between stocks and options to provide effort incentives to a risk-averse manager. We show that stocks can dominate options as a means of motivation only if nonviability risk is substantial, as in financially distressed firms or start-ups. Options dominate stocks for other firms. These results hold regardless of the existing portfolio of the manager. We provide empirical evidence that higher bankruptcy risk is indeed correlated with more use of stock.

We are grateful to Sreedhar Bharath and Tyler Shumway for sharing with us their code for calculating the KMV-Merton expected default frequencies, and to John Graham for sharing with us his simulated marginal tax rates. We thank an anonymous referee, Kerry Back, Martin Cripps, Peter DeMarzo, Bart Hamilton, Mike Faulkender, Mariassunta Giannetti, Armando Gomes, Yaniv Grinstein, Wayne Guay, Ilan Guttman, Dave Larcker, Glenn MacDonald, Todd Milbourn, Maureen O'Hara (the editor), Chandra Seethamraju, Neal Stoughton, Jeff Zwiebel, seminar participants at Colorado-Boulder, Michigan, Northwestern, UCSD, and Washington University, as well as participants at the FRA 2004, EFA 2005, FIRS 2006, and Stanford 2006 Summer Camp for helpful comments and suggestions. Mikhail Pevzner provided excellent research assistance.


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