We design and derive a pricing model for an executive stock option with a strike price indexed to a benchmark and investigate its valuation and incentive implications. In both up and down markets, the indexed option filters out common risks beyond the executive's control, thereby increasing the efficiency of incentive contracts. The indexed option has a different payoff structure and much lower initial value than a traditional option. Incentive effects 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. 2000 Elsevier Science Ltd.
