LIMITED-LIABILITY AND THE UNDERLYING-ASSET CONSTRAINT - ON THE USE OFSHARE-DERIVATIVE CONTRACTS TO RESOLVE AGENCY PROBLEMS

The issue of whether agency problems can be resolved by using standard derivative contracts continues to interest students of incentive stru ctures of organizations. In this paper, we identify under limited liab ility a necessary and sufficient condition for standard share-derivati ve contracts to resolve moral hazard problems. This condition is remar kably simple: in addition to having large enough expected profit, the insiders of the firm must be able to hold combinations of call and put options in excess of the available underlying assets. Feasibility of delivery makes this condition not credible in the capital markets. The refore, to circumvent this constraint one must have resort to private arrangements. This explains why incentive contracts often involve elem ents such as bonuses, penalties, and promotions, that are not able to be mimicked by standard derivative contracts.