Working Paper: NBER ID: w8052
Authors: Brian J. Hall; Kevin J. Murphy
Abstract: We employ a certainty-equivalence framework to analyze the cost and value of, and pay/performance incentives provided by, non-tradable options held by undiversified, risk-averse executives. We derive Executive Value' lines, the risk-adjusted analogues to Black-Scholes lines, and distinguish between executive value' and company cost.' We demonstrate that the divergence between the value and cost of options explains, or provides insight into, virtually every major issue regarding stock option practice including: executive views about Black-Scholes measures of options; tradeoffs between options, stock and cash; exercise price policies; connections between the pay-setting process and exercise price policies; institutional investor views regarding options and restricted stock; option repricings; early exercise policies and decisions; and the length of vesting periods. It also leads to reinterpretations of both cross-sectional facts and longitudinal trends in the level of executive compensation.
Keywords: Executive Compensation; Stock Options; Agency Theory
JEL Codes: G30; G34
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Company's cost of granting options exceeds value to executives (M12) | Divergence impacts aspects of executive compensation (M12) |
| Divergence impacts aspects of executive compensation (M12) | Executives argue that Black-Scholes valuations are inflated (G13) |
| Divergence impacts aspects of executive compensation (M12) | Executives demand large premiums to exchange options for cash (M12) |
| Structure of option grants (G13) | Incentives created for executives (M52) |
| Early exercise of options (G13) | Increases efficiency by reducing value-cost divergence (D61) |