The Subjective Valuation of Indexed Stock Options and Their Incentive Effects

We analyze the potential role of indexed stock options in future pay-for-performance executive compensation contracts. We present a unified framework for index-linked stock options, discuss their incentive effects, argue that indexation schemes based on the capital-asset pricing model (CAPM) are the most suitable for executive compensation, and derive a subjective pricing model for the class of CAPM-based indexed stock options. Contrary to earlier work, executives would not be motivated to take on investment projects with high idiosyncratic risk once their lack of wealth diversification and degree of risk aversion are factored into the analysis.