In this paper shareholders face the trade-off between providing managersudwith incentives to exert beneficial effort and to engage in costly fraudulent activity. We solveudfor the optimal compensation package, given that shareholders can either grant (restricted)udstock or stock options and given fixed average compensation costs. We show that if the negativeudeffect of fraud on the company’s value is sufficiently large then stock based compensationudis optimal. Otherwise, stock option based compensation is optimal. Furthermore, we showudthat the fraud to effort ratio is increasing in the strike price and that the optimal strike priceudis decreasing in the size of the negative effects of fraud on the company’s value.
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