Indexed executive stock options

We design and derive a pricing model for an executive stock option with a s trike price indexed to a benchmark and investigate its valuation and incent ive implications. In both up and down markets, the indexed option filters o ut common risks beyond the executive's control, thereby increasing the effi ciency of incentive contracts, The indexed option has a different payoff st ructure and much lower initial value than a traditional option. Incentive e ffects of the indexed option also differ from those of traditional options. We design an optional penalty function to reduce the payoff if executives manipulate specified model parameters such as volatility. (C) 2000 Elsevier Science S.A. All rights reserved. JEL classification: J33; G13.