Working Paper: NBER ID: w7548
Authors: Brian J. Hall; Kevin J. Murphy
Abstract: Although exercise prices for executive stock options can be set either below or above the grant-date market price, in practice virtually all options are granted at the money. We offer an economic rationale for this apparent puzzle, by showing that pay-to-performance incentives for risk-averse undiversified executives are typically maximized by setting exercise prices at (or near) the grant-date market price. We provide an operationally useful alternative to Black-Scholes (1973) for the purpose of both valuing executive stock options and measuring the incentives created by options. Our framework has implications not only for exercise-price policies, but also for indexed options, option repricings, exchanges of cash for stock-based compensation, and the design of bonus plans.
Keywords: No keywords provided
JEL Codes: J01; J3; G0; G3
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exercise price (G13) | pay-to-performance incentives (J33) |
| exercise price (G13) | likelihood of payout (G35) |
| pay-to-performance incentives (J33) | executive behavior (L20) |
| exercise price (G13) | executive value line slope (D46) |
| executive value line slope (D46) | incentives from stock options (M52) |
| exercise price (G13) | company value (D46) |