Managerial responses to incentives: Control of firm risk, derivative pricing implications, and outside wealth management

We model a firm’s value process controlled by a manager maximizing expected utility from restricted shares and employee stock options. The manager also controls allocation of his outside wealth, which allows partially hedging of his exposure to firm risk. Managerial control increases the expected time to exercise for his employee stock options. It also reduces the gap between his certainty equivalent and the firm’s Fair Value for his compensation, but that gap remains substantial. Managerial control also causes traded options to exhibit an implied volatility smile. With costly control the same basic patterns remain, but the manager’s risk-taking is dampened.