eprintid: 164
rev_number: 4
eprint_status: archive
userid: 6
dir: disk0/00/00/01/64
datestamp: 2008-10-07
lastmod: 2015-05-29 19:48:30
status_changed: 2009-04-08 16:55:08
type: report
metadata_visibility: show
item_issues_count: 0
creators_name: Cottrell, Tom
creators_name: Calistrate, Dan
title: Designing Incentive-Alignment Contracts in a Principal-Agent Setting in the Presence of Real Options
ispublished: pub
subjects: finance
studygroups: ipsw4
companyname: Stern Stewart and Co.
full_text_status: public
abstract: We develop a model of incentive compensation for optimal upgrades supplied by an outsourced Information Technology department. We first consider the problem when the rate of technological development is certain and there are no information asymmetries between the parties. We extend this to allow private information between the principal and an agent acting as an external supplier of information technology upgrades. Based on the model in these simple circumstances, we then model uncertain technological improvements, where improvements evolve as Geometric Brownian motion, and there is benefit to flexibility in the timing of the upgrade.  We are aware of contracts, known as "evergreen upgrades", where a principal pays for upgrades at specified intervals. We find little support for such a contract in our model, and the loss of flexibility in the timing of upgrades is puzzling. The Stern-Stewart problem encourages us to consider just such instances, where contracts limit flexibility that it may in the interest of both parties to retain.
problem_statement: Consider a firm with shareholders (considered to be the Principal, as one entity) and management (the Agent). The Agent is compensated based on real increases in value. Should the Principal accept low increases now, based on estimates of considerable increases in the future(perhaps after the term of present management)? Should the Principal insist on the highest possible short term increase, and compensate or punish the Agent accordingly? Given that the Principal's knowledge will not in general be as complete as that of the Agent, and that there is uncertainty involved at several levels, what is the best strategy for the Principal and for the Agent to follow?
date: 2000
date_type: published
pages: 16
citation:   Cottrell, Tom and Calistrate, Dan  (2000) Designing Incentive-Alignment Contracts in a Principal-Agent Setting in the Presence of Real Options.  [Study Group Report]     
document_url: http://miis.maths.ox.ac.uk/miis/164/1/incentive_compensation.pdf