The executive option

Most of us know that the value of an option increases when the uncertainty of the underlying increases. This is because options provide asymmetric payoff to the holder, allowing her to exercise the option in favorable circumstances and simply walk away in other situations. In a similar fashion, executives in large companies seem to hold management options provided to them by the shareholders of the firm. As uncertainty increases, the value of these management options increase. They allow the managers to exercise them if the company does well and claim “no-fault” if it does not. This has led to the culture of “no-consequence” management in which the chiefs claim high bonuses if the company (and the economy in general) gets lucky and blame everything else if things do not work out.

This has been ably demonstrated recently by investment banking executives who have claimed high bonuses in good times and appealed for bailouts in bad times. More subtly, the same phenomena have been happening in every other company. Managers of most large companies typically claim that the success of the company is due to their hard work but often blame the economy, government and other factors if the company fails. This is an option held by the managers of the firm. They exercise these options to their own benefits in good times and simply walk away in bad times.

Executive options will increase in value when the uncertainty of outcomes increases. The value of the executive, thus, is higher under chaos than in a stable regime. This means that it is dominant for executives of firms to increase uncertainty that automatically enhances their own value. A chaotic economy, thus, provides the executives of firms (especially the large ones) an automatic increase in worth. To correct this situation, negative bonuses and other creative incentives have to be implemented to make the pay-offs symmetric. Otherwise, we will prolong the “no-consequence” management culture that will make the economy worse off, save the executives.