While stock options are commonly used in managerial compensation to pro- vide desirable incentives, their adverse e.ects have not been widely appre- ciated. We show that a call-type contract creates incentives to distort the choice of investment risk. Relative to the risk level that maximizes ˉrm value, a call option contract can induce too much or too little corporate risk- taking, depending on managerial risk aversion and the underlying investment technology. We show that inclusion of lookback call options in compensa- tion packages has desirable countervailing e.ects on managerial choice of corporate risk policies and can induce risk policies that increase shareholder wealth. We argue that lookback call options are analogous to the observed practice of option repricing.
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