Executive Stock Options as a Screening Mechanism

We study how and when option grants can be the optimal compensation to screen low-ability executives. In a dynamic setting, we consider the problem of a risk-neutral firm that tries to hire a risk-averse executive whose actions can affect the expected return and volatility of the stock price. Even if the optimal compensation for all types of executives is stock under complete information, it might be optimal to offer options under incomplete information, although a pooling equilibrium in which the optimal contract is stock is also possible. We show that the likelihood of using options increases with the dispersion of types and the size of the firm, and decreases with the availability of growth opportunities for the firm.