When Contracts Require Risk-Averse Executives to Hold Equity: Implications for Option Valuation and Relative Performance Evaluation

Abstract

A growing body of literature suggests that because an executive is risk-averse and undiversified, he values equity compensation and incentives at less than market value. This discount on valuation is driven by the assumption that the executive is constrained from rebalancing his portfolio following an equity grant, and as such, the payment of equity compensation permanently increases the risk and incentives borne by the executive. We relax this exogenous assumption, and assume that firms contract with their executives and agree upon a specified level of risk. Firms expect and require that executives rebalance their portfolios when equity risk rises above or falls below the contracted level. Under these assumptions, we show that the executive does not discount the value of equity compensation or changes in the value of his equity portfolio. The notion that firms write contracts that require executives to hold equity also suggests that executive contracts are more consistent with relative performance evaluation than has been found in prior empirical research. Specifically, this type of contract requires executives to reduce the fraction of their total wealth held in a well-diversified portfolio and to increase their investment in firm equity.