Indexed Executive Stock Options With Ratchet Mechanism and Average Prices

Abstract

In this paper, we design a new type of executive stock option, dubbed the stock option with ratchet mechanism and average prices. We also derive its pricing model and investigate its incentive implications. Like an indexed option, the proposed option links its strike price to a benchmark, so as to eliminate common risks beyond the reach of the executive's control and reinforce the option's incentive effect. With the ratchet mechanism, the proposed option enables its holder to enjoy a series of compensations spread over a period of time, thereby developing the executive's loyalty towards the firm. Furthermore, in order to minimize impacts of a rough market movement and those of an eventual price manipulation, average prices are taken into account in the payoff of the proposed option.