Stock Options as a Screening Mechanism

Abstract

We show that a possible explanation for the widespread use of options in compensation contracts might be that they provide a way to screen executives. In particular, we consider the problem of a risk-neutral firm that tries to hire a risk-averse executive. There are several types of executives, of varying quality. Executives know their own types, but the firm only knows the probability distribution of types. Executives affect stock price dynamics through the choice of volatility, and by applying costly effort. The firm offers executives a compensation contract consisting exclusively of stock or options. We show that the optimal contract with type uncertainty requires more leverage than contracts with perfect information. Even when the optimal contract with perfect information requires stock compensation, in the case of incomplete information it might be optimal to offer options compensation to filter out bad executives.