The interaction between equity-based compensation and debt in managerial risk choices

Abstract

This paper examines the risk incentives of traditional and non-traditional call options in the context of a levered firm where managers under-invest due to risk aversion. Our results contrast with those presented in the literature inasmuch as lookback calls do not always induce higher risk taking than regular calls, and managers always prefer a combination of regular calls and shares of stock in their compensation package as opposed to only company shares. We also show that Asian options outperform both plain-vanilla and other nonstandard options in inducing higher risk taking and, thereby, are a superior remedy for alleviating the agency costs of deviating from the optimal volatility level. Finally, we shed new insights that better clarify the incorrect arguments found in the literature regarding the delta of regular and lookback calls.