Options in Agency with Binary Uncertainty

Óscar Gutiérrez and Vicente Salas-Fumás

Manchester School, 2014, vol. 82, issue 2, 218-236

Abstract: type="main">

This paper uses a stylized agency model to evaluate the economic efficiency of options contracts when pay-off uncertainty is bimodal, a situation rather common when projects either ‘fail’ or ‘succeed’. We find that ‘options’ are strictly preferred to ‘stock’ (i.e. linear contracts) when output uncertainty is large, i.e. when the spread between the modes of the pay-off distribution is sufficiently high.

Date: 2014
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