Incentive Contract Design Research Articles

Options on the Minimum or the Maximum of Two Average Prices

This paper studies options on the minimum/maximum of two average prices. We provide a closed-form pricing formula for the option with geometric averaging starting at any time before maturity. We show overwhelming numerical evidence that the variance reduction technique with the help of the above closed-form solution dramatically improves the accuracy of the simulated price of an option with arithmetic averaging. The proposed options are found widely applicable in risk management and in the design of incentive contracts. The paper also discusses some parity relationships within the family of average-rate options and provides the upper and lower bounds for the proposed options with arithmetic averaging.

Options on the minimum or the maximum of two average prices

This paper studies options on the minimum/maximum of two average prices. We provide a closed-form pricing formula for the option with geometric averaging starting at any time before maturity. We show overwhelming numerical evidence that the variance reduction technique with the help of the above closed-form solution dramatically improves the accuracy of the simulated price of an option with arithmetic averaging. The proposed options are found widely applicable in risk management and in the design of incentive contracts. The paper also discusses some parity relationships within the family of average-rate options and provides the upper and lower bounds for the proposed options with arithmetic averaging.

The Valuation of Assets under Moral Hazard

ABSTRACTThe design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of managers can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms.

The Valuation of Assets under Moral Hazard

The design of managerial incentive contracts is examined in a setting in which economic agents are risk averse, and the actions of managers can affect asset returns which contain both systematic and idiosyncratic risks. It is shown that in the absence of moral hazard, owners of assets will insure managers against idiosyncratic risks, but with moral hazard, contracts will depend on both systematic and idiosyncratic risks. The traditional recommendation of asset pricing models, namely, to focus only on systematic risks, is thus proved to be valid only when there is no moral hazard. The major empirically testable predictions of the model are (1) managerial incentive contracts will generally depend on systematic as well as idiosyncratic risks, (2) idiosyncratic risks will generally be important in investment decisions, (3) the managers of firms with relatively high levels of idiosyncratic risks will have compensations that are less dependent on their firms' excess returns, and (4) the compensations of managers of larger firms will be relatively more dependent on the excess returns of their firms. EXTANT ASSET VALUATION MODELS assume that the probability distribution of asset returns is exogenous to the valuation process itself and beyond the influence of those involved in the ownership and management of the asset. Since the plausibility of such an assumption is suspect for an actively managed asset, our main objective is to relax this assumption and characterize Pareto optimal managerial incentive contracts in a setting in which managers can affect asset returns through ex post unobservable actions. The economy has two types of economic agents-principals and agents. Principals, who may be risk averse, are endowed with capital, but they lack the skills to efficiently manage the assets they own. Thus, they must hire managers who have mean-variance utility functions and are in elastic supply.' Managers are assumed to possess no initial capital and, consequently, they must sell their services to satisfy their consumption needs. The incentive contracts by which managers are compensated are linear. For simplicity, all managers have identical preferences and skills. Allowing principals to be risk averse is important if the asset's profitability is not a diversifiable risk. The assumption of mean-variance utility is common in portfolio theory. The linearity constraint on incentive contracts is admittedly

The Influence of Incentive Provisions on Project Management

Our previous speaker, Mr. Blyth, in his paper on the Design of Incentive Contracts, has given us a lucid explanation of the basic principles of incentives and examples of cost, performance and delivery conditions which could be used as incentives and the objectives to which they could be directed.Following on this paper, one could initiate a discussion on the basic philosophy behind the use of incentives, whether the incentives as stated are likely to be achieved, and propose various alternative methods of achieving these objectives without using contractual conditions. I have no doubt that many points such as these will be raised later during the discussion.

Design of Incentive Contracts, Basic Principles

Some people claim that there is nothing new under the sun. Certainly incentive contracting is not new. The Navy Department boasts of Pepys using delivery incentives in the form of penalties and bonuses in ship contracts 300 years ago. In America, the War Department included a performance incentive in the Wright brothers' aircraft contract in 1907, providing for a 10% bonus for each mile per hour the aircraft would perform in excess of 40mph(18m/s).