Title: Executive compensation using relative-performance-based options
Description: This paper examines how an option plan that rewards managers for firm performance relative to some market or industry benchmark should be structured, and gauges the deadweight costs of such a plan. Relative-performance-based compensation advocates contend that conventional stock options do not adequately discriminate between strong and weak managers, typically suggesting "indexed options," that is, options with an exercise price linked to a market or industry index, as a remedy. A close examination of indexed options, however, reveals a fundamental problem: indexed options do not function as intended. Instead, their payoff remains highly sensitive to market or industry price movements. This paper proposes an alternative option design that does remove the effects of the desired benchmark. This structure uses an option with a fixed exercise price, where the underlying asset is a portfolio comprised of the firm's stock hedged against market and industry price movements. The paper then compares the deadweight cost of this performance-benchmarked option to that of a conventional stock option. Deadweight costs inevitably accompany any equity-based compensation program, because the firm's managers must be exposed to firm-specific risks to properly align incentives, and this forced concentrated exposure prevents managers from optimal portfolio diversification.