Leverage decision and manager compensation with choice of effort and volatility

Abstract

We study the incentive effects of granting levered or unlevered stock to a risk-averse manager. The stock is granted by risk-neutral shareholders who choose leverage and compensation level. The manager applies costly effort and selects the level of volatility, both of which affect expected return. The results are driven by the attempt of the risk-neutral shareholders to maximize the value of their claims net of the compensation package. We consider a dynamic setting and find that levered stock is optimal for high-type managers, firms with high momentum, large firms, and firms for which additional volatility only implies a modest increase in expected return. JEL Classification: C61, G39

Environment and Financial Markets

“…This reminds the problem of executive options by Cadenillas et al in [1] with main two differences: first -at least one part of the award should depend on the temporal mean of the underlying process, and second -options can be traded.…”

“…The function H must be specified. Th function Ln is not the utility of an agent as it was proposed in [1], which remains linear in our approach, but stands here for the form of the award. Now…”

“…This situation slightly resembles the study of Executive stock options in [1]. However we must work with more difficult to analyze kind of awards based on the temporal mean and also with bounded models that represents more complications as we shall see in Section 3.…”

Executive Stock Options as a Screening Mechanism

“…The framework in this paper is similar to that of Cadenillas, Cvitanić and Zapatero (2004), but the main difference is that in that paper the firm always knows the type of the executive. In particular, in this paper we consider the problem of a risk-neutral firm that has to decide whether to grant stock or options as compensation to a riskaverse executive that can affect the dynamics of the stock by applying costly effort or choosing the level of volatility.…”

Optimal Investment for Executive Stockholders with Exponential Utility

“…They give closed-form solutions for the optimal investment strategies and the work effort which the executive will apply in a constant relative risk aversion framework. Other technical papers that consider similar dynamic pincipal-agent problems are Cadenillas, Cvitanić and Zapatero (2004) or Ou-Yang (2003), for example.The scope of this paper is to extend the work of Desmettre, Gould and Szimayer (2010) to a constant absolute risk aversion setting and thus to investigate the robustness of the model proposed by them. We consider an executive who is characterized by an absolute risk aversion parameter (η) and the two work effectiveness parameters inverse work productivity (κ) and disutility stress (α).…”