RISK-FREE INCENTIVE CONTRACTS - ELIMINATING AGENCY COST USING OPTION-BASED COMPENSATION SCHEMES

This paper demonstrates that options can be used to eliminate agency costs in the formal agency model. When an agent's action can determine the mean of future cash flows assumed to follow a binomial random walk, the principal can design a compensation package using options which are hedged by other components of the compensation package to be risk-free only if the agent takes the action desired by the principal and therefore risky if the agent is shirking. Thus, a risk- (and effort-) averse agent can be given incentives to take the action desired by the principal without sacrificing optimal risk sharing, even when the agent's action cannot be observed, either directly or indirectly.