| Corporate governance is generally considered to be the set of complementary mechanisms that help align the actions and choices of managers with the interests of the shareholders. An important and often debated component of the governance structure is the compensation contract selected for providing remuneration to managers (for example, the constitution of the compensation contract, the level of remuneration and the efficiency of the contract). Executive compensation has been the subject of extensive prior research. Stock and option compensation are main aspects of corporate governance.Stock options, an important component of executive compensation contracts, have been widely used in the executive compensation contracts. From the perspective of agency theory, stock options tie the remuneration and wealth of the agents to the future stock price of the firm directly, increase the sensitivity of the remuneration to performance and stimulate the executives to maximize the wealth of the shareholders, minimizing the agency cost. However, while the proportion of stock options in compensation contracts increases, there are considerable academic and professional debates on the effectiveness of executive stock option incentive. Similar to much of the corporate finance and corporate governance literatures, research on stock and option-based compensation and incentives has generated not only useful insights, but also has produced many contradictory findings. However, the key in these literatures is identical, the effect of the compensation contract.According to the form of the incentive model, the factors that affect the final solution of the incentive problem involve (1) the valuation of the stock options awarded by the shareholders (the objectivity and precision of the option pricing model), (2) the specific form of the stock options, and (3) the executives’ subjective valuation of the stock options (the executives’ valuation of the stock options under heterogeneous preference). In this paper, the effectiveness and consistent optimality of executive stock option incentive mechanism will be considered from the perspectives such as stock option pricing, form design of the stock options and the executives’ heterogeneous preference.This paper primarily develops the option pricing model from two main aspects, the volatility and the measurement of the stock price at the expiration date. The option pricing model with an implied volatility, general error distribution stochastic volatility, is given. Meanwhile, considering the specific features of the stock markets, the options are set to be path-dependent options, the mean-adjusted double knock-out options. The modified option pricing model gives more accurate portrayal of the option value.Since the incentive effect of single layer option presents a non-uniform concave shape, desired incentive effect can not be achieved through such options. So multiple layers options (the options with several different exercise prices) should be introduced in. Empirical evidence has shown that executive stock option incentive mechanism based on multiple layers stock options is uniformly superior to that under single layer stock options. And to some extent, the uniform concavity of incentive effect is achieved. Namely, multiple layers stock options are effective form of executive stock option compensation.This paper mainly discusses the heterogeneous preference of the executives such as variable risk aversion, variable loss aversion, the endowment effect and the executives’ overconfidence and the impact of these factors to the effectiveness and uniform optimality of the incentive. Because the values calculated by the standard option pricing model or the modified ones in this paper are both the objective value of the option, while the real value of incentive option is the executives’ subjective valuation of it. And then, the introduction of heterogeneous preference such as loss aversion, endowment effect and overconfidence to the study of executive stock option incentive mechanism is particularly significant.The analysis and results show that, stock option compensation is indeed an effective incentive mechanism by appropriate modification of option pricing model, proper design of options, and the uniform optimality can be obtained under certain conditions. Moreover, the analysis involving the heterogeneous preference such as variable risk aversion, loss aversion and overconfidence shows that, the executive stock option incentive mechanism would be distinct in the capital markets with different features. And the overconfidence impacts the effect of stock option incentive; higher degree of overconfidence corresponds to higher level of effort and higher effect of stock option incentive as well. |
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