Executive Stock Options

Abstract

As a part of the compensation package many companies provide executives with executive stock options, which are call options with additional restrictions. They provide some financial advantages to the executives and help the company retain the service of the executives who improve the company’s earnings and management.

Until recently the values of the executive stock options were not required to be disclosed in the company?s financial reports. But recent statements from the Financial Accounting Standards Board (FASB) have made it necessary to value these executive stock options. The valuation of executive stock options is also required for investors and financial practitioners. This paper considers the award of performance-based executive stock options when the stock price at the time of stock option award exceeds a given preassigned value. It is assumed that the stock price follows a geometric Brownian motion, and that the number of stock options awarded at any time depends on the stock price at that time.

A valuation formula is derived using the method of Esscher transforms for a multiyear award plan. The closed-form formula derived is similar to the Black-Scholes formula for options and utilizes the standard bivariate normal distribution function, which is available in statistical software. In this paper the number of stock options awarded is assumed to be in a specific form, but the theory presented can be modified to suit other forms of award structure. Moreover, by suitable choice of parameters, a valuation formula is also presented for the award of fixed-value executive stock options grants; this formula is also in a closed form and involves cumulative distribution values of the standard normal random variable. Numerical illustrations of the use of the valuation formulas are presented.     

How Might Companies Value ESOs?

There has been a steady growth in the use of employee equity compensation plans, and in the use of executive stock options (ESOs) in particular, along with a rise in shareholder and public perceptions that the values of compensation plans are not always fully disclosed. The IFSA of Australia recently called for separate reporting in financial statements of numbers and values of ESOs. Companies, when negotiating employment contracts, frequently agree to compensate an executive if a share option plan is subsequently not approved by shareholders. These facts suggest that reporting the value of an ESO plan is a useful and important exercise. We outline a model for the valuation of ESOs typically issued by Australian listed companies and illustrate the application of the model with a case study.     

IRC Section 162(m) and the law of unintended consequences

In 1993, Section 162(m) of the U.S. Internal Revenue Code was passed into law with the intent to reign in outsized executive compensation by eliminating the tax-deductibility of executive compensation above $1 million unless the excess compensation was performance-based. An unintended consequence of the legislation was that executives' total compensation actually increased in the post-1993 period, largely due to a dramatic increase in employee stock options. Employee stock options have unintended consequences of their own. The economic value of stock options may be influenced by executive decision-making when the options are valued using the Black-Scholes model or some variant thereof. Our findings suggests an unintended consequence that executives used their discretion to positively impact the performance-based component of their compensation through actions increasing share price volatility and reducing dividend yields, assumptions implicit in option valuation models.     

American-style Indexed Executive Stock Options

This paper develops a new pricing model for American-style indexed executive stock options. We rely on a basic model framework and an indexation scheme first proposed by Johnson and Tian (2000a) in their analysis of European-style indexed options. Our derivation of the valuation formula represents an instructive example of the usefulness of the change-of-numeraire technique. In the paper's numerical section we implement the valuation formula and demonstrate that not only may the early exercise premium be significant but also that the delta of the American-style option is typically much larger than the delta of the otherwise identical (value-matched) European-style option. Vega is higher for indexed options than for conventional options but largely independent of whether the options are European- or American-style. This has important implications for the design of executive compensation contracts. We finally extend the analysis to cover the case where the option contracts are subject to delayed vesting. We show that for realistic parameter values, delayed vesting leads only to a moderate reduction in the value of the American-style indexed executive stock option.     

The impact of the market portfolio on the valuation,incentives and optimality of executive stock options

This paper examines the effect on valuation and incentives of allowing executives receiving options to trade on the market portfolio. We propose a continuous time utility maximization model to value stock and option compensation from the executive's perspective. The executive may invest non-option wealth in the market and riskless asset but not in the company stock itself, leaving them subject to firm-specific risk for incentive?purposes. Since the executive is risk averse, this unhedgeable firm risk leads them to place less value on the options than their cost to the company.

By distinguishing between these two types of risks, we are able to examine the effect of stock volatility, firm-specific risk and market risk on the value to the executive. In particular, options do not give incentive to increase total risk, but rather to increase the proportion of market relative to firm-specific risk, so executives prefer high beta companies. The paper also examines the relationship between risk and incentives, and finds firm-specific risk decreases incentives whilst market risk may decrease incentives depending on other parameters. The model supports the use of stock rather than options if the company can adjust cash pay when granting stock-based compensation.     

The Pricing of Risk and Sentiment: A Study of Executive Stock Options

Option pricing models accounting for illiquidity generally imply the options are valued at a discount to the Black‐Scholes value. Our model considers the role of sentiment, which offsets illiquidity. Using executive stock options and compensation data from 1992 to 2004 for S&P 1500 firms, we find that executives value employee stock options (ESOs) at a 48% premium to the Black‐Scholes value. These premia are explained by a sentiment level of 12% in risk‐adjusted, annualized return, suggesting a high level of executive overconfidence. Subjective value relates negatively to illiquidity and idiosyncratic risk, and positively to sentiment in all specifications, consistent with the offsetting roles of sentiment and risk aversion.     

Option Awards for Australian CEOs: The Who, What and Why

The compensation structure for Australian CEOs, and especially the extent to which they receive executive stock options, is explored. Evidence suggests that the award of executive stock options is common in Australia, but not in as systematic a manner as has been documented for US CEOs. Where ESOs are awarded, they form a significant component of total compensation, even allowing for limitations in the way we approximate their value. Modelling the use of ESOs shows relatively few empirical regularities, other than a positive association between firm size and ESO use. This is consistent with a view that ESOs are a form of "rent extraction" by CEOs, but it may also reflect a bias towards their use created by accounting rules.     

The Subjective Valuation of Indexed Stock Options and Their Incentive Effects

We analyze the potential role of indexed stock options in future pay‐for‐performance executive compensation contracts. We present a unified framework for index‐linked stock options, discuss their incentive effects, argue that indexation schemes based on the capital‐asset pricing model (CAPM) are the most suitable for executive compensation, and derive a subjective pricing model for the class of CAPM‐based indexed stock options. Contrary to earlier work, executives would not be motivated to take on investment projects with high idiosyncratic risk once their lack of wealth diversification and degree of risk aversion are factored into the analysis.     

Incentive effects of executive compensation and the valuation of firm assets

This paper examines how executive compensation influences the market value of the firm's assets. After controlling for endogeneity, we find that boards have set the incentive to incur risk (vega) to maximize shareholder value, but that incentives to increase returns (delta) do not maximize shareholder value. We also find that current levels of cash compensation do not maximize shareholder value. Finally, we consider the moneyness of stock options. We find that the level of at- and out-of-the money options maximize shareholder value, but the level of in-the money options do not maximize shareholder value.     

Expensing options solves nothing

The use of stock options for executive compensation has become a lightning rod for public anger, and it's easy to see why. Many top executives grew hugely rich on the back of the gains they made on their options, profits they've been able to keep even as the value they were supposed to create disappeared. The supposed scam works like this: Current accounting regulations let companies ignore the cost of option grants on their income statements, so they can award valuable option packages without affecting reported earnings. Not charging the cost of the grants supposedly leads to overstated earnings, which purportedly translate into unrealistically high share prices, permitting top executives to realize big gains when they exercise their options. If an accounting anomaly is the problem, then the solution seems obvious: Write off executive share options against the current year's revenues. The trouble is, Sahlman writes, expensing option grants won't give us a more accurate view of earnings, won't add any information not already included in the financial statements, and won't even lead to equal treatment of different forms of executive pay. Far worse, expensing evades the real issue, which is whether compensation (options and other-wise) does what it's supposed to do--namely, help a company recruit, retain, and provide the right people with appropriate performance incentives. Any performance-based compensation system has the potential to encourage cheating. Only ethical management, sensible governance, adequate internal control systems, and comprehensive disclosure will save the investor from disaster. If, Sahlman warns, we pass laws that require the expensing of options, thinking that's fixed the fundamental flaws in corporate America's accounting, we will have missed a golden opportunity to focus on the much more extensive defects in the present system.     

Executive stock-based compensation and firms’ cash payout: the role of shareholders’ tax-related payout preferences

We hypothesize that the structure of executive stock-based compensation helps to align managers’ payout choices with shareholders’ tax-related payout preferences. Specifically, stock options, which are not dividend-protected, can deter self-interested executives from using dividends as a form of payout. In contrast, restricted stock, which is dividend-protected, is more likely to induce the use of dividends. Relatedly, shareholders’ preferences for dividends, which are taxed as ordinary income, can depend on the income tax consequences of dividends relative to those of long-term capital gains. To test our hypothesis, we investigate whether the exogenous changes in shareholders’ tax-related payout preferences following the 2003 dividend tax rate reduction result in predictable shifts in executive stock-based compensation and in managers’ payout choices. Consistent with our prediction, we find a positive relation between the increased use of dividends in firms’ payouts and the increased (decreased) use of restricted stock (stock options) in executive compensation, particularly for firms with a greater percentage ownership by individual investors and with lower costs associated with modifying the structure of their compensation plans. Our investigation of the role of shareholders’ tax-related payout preferences in the design of executive stock-based compensation extends the prior literature that has largely focused on the role of incentive contracts in inducing managerial effort, risk taking, and retention.     

The role of equity compensation in reducing inefficient investment in labor

We investigate whether equity compensation incentivizes executives to make efficient labor investment decisions. In doing so, we examine the extent to which stock options and restricted stock differentially influence labor investment decisions. Consistent with theoretical predictions, we find that stock options exacerbate, while restricted stock mitigates, inefficient labor investment. The effect of stock options (restricted stock) are weaker (stronger) for financially constrained firms. Our results are robust to alternative proxies for inefficient labor investment and when addressing a range of endogeneity concerns. Our research demonstrates that stock options and restricted stock matter in executives' labor investment decisions, but in different ways. Our findings have implications for future research, suggesting that stock options and restricted stock need to be separately considered when examining the impact equity compensation has on capital or investment decision making; and for executive remuneration practice.     

商业银行管理层股票期权激励:特征及其影响因素——基于美国银行业的实证研究

本文以1996～2005年间美国43家代表性商业银行和98家制造业企业为样本,实证分析了商业银行管理层股票期权补偿激励的特征和影响因素。结果表明:商业银行管理层股票期权补偿占总报酬补偿比例的变化呈现出先升后降的倒U型趋势,商业银行管理层股票期权补偿占总报酬补偿的比例显著地低于制造业的这一比例;管理层股票期权补偿与商业银行成长机会、外部董事比例存在着显著的正相关关系,而与杠杆比率呈显著负相关;资产规模、管理层股票补偿对股票期权补偿水平的影响为负,但不显著;行业管制与管理层股票期权补偿费用的会计处理方法对银行业股票期权补偿有显著的影响。     

Valuation of a Repriceable Executive Stock Option

We introduce a path-dependent executive stock option. The exercise price might be reduced when both the firm’s stock price and a stock market index fall greatly. The repriceable executive stock option has a simple payoff that may be used for realistic executive rewards. We show the valuation formula, and compute the probability of the repriceable executive stock option expiring in-the-money. Both price and probability are important pieces of quantitative information when choosing an executive compensation package.     

Financial crisis and bank executive incentive compensation

We study the executive compensation structure in 14 of the largest U.S. financial institutions during 2000–2008. We focus on the CEO's purchases and sales of their bank's stock, their salary and bonus, and the capital losses these CEOs incur due to the dramatic share price declines in 2008. We consider three measures of risk-taking by these banks. Our results are mostly consistent with and supportive of the findings of Bebchuk, Cohen and Spamann (2010), that is, managerial incentives matter — incentives generated by executive compensation programs are correlated with excessive risk-taking by banks. Also, our results are generally not supportive of the conclusions of Fahlenbrach and Stulz (2011) that the poor performance of banks during the crisis was the result of unforeseen risk. We recommend that bank executive incentive compensation should only consist of restricted stock and restricted stock options — restricted in the sense that the executive cannot sell the shares or exercise the options for two to four years after their last day in office. The above incentive compensation proposal logically leads to a complementary proposal regarding a bank's capital structure, namely, banks should be financed with considerably more equity than they are being financed currently.     

Revisiting the incentive effects of executive stock options

We develop a multiperiod framework to evaluate the incentive effects of executive stock options (ESOs). For a given increase in the grant-date firm stock price (and a concurrent increase in return volatility), the increment of total value at the vesting date acts as a proxy for the incentive effects of ESOs. If the option is attached to the existing contract without adjusting cash compensation, we suggest that a firm should not always fix the strike price to the grant-date stock price; instead, the strike price should vary with the length of the vesting period. We also show that, compared with at-the-money options, restricted stock generates greater incentives to increase stock prices in some scenarios, especially when equity-based awards are vested early. If the vesting period is long, the firm could grant options instead of restricted stock to maximize incentives.     

Managerial Incentives and Stock Price Manipulation

We present a rational expectations model of optimal executive compensation in a setting where managers are in a position to manipulate short‐term stock prices and the manipulation propensity is uncertain. We analyze the tradeoffs involved in conditioning pay on long‐ versus short‐term performance and show how manipulation, and investors' uncertainty about it, affects the equilibrium pay contract and the informativeness of prices. Firm and manager characteristics determine the optimal compensation scheme: the strength of incentives, the pay horizon, and the use of options. We consider how corporate governance and disclosure regulations can help create an environment that enables better contracting.     

Ironing out the kinks in executive compensation: Linking incentive pay to average stock prices

Traditional stock option grant is the most common form of incentive pay in executive compensation. Applying a principal-agent analysis, we find this common practice suboptimal and firms are better off linking incentive pay to average stock prices. Among other benefits, averaging reduces volatility by about 42%, making the incentive pay more attractive to risk-averse executives. Holding the cost of the option grant to the firm constant, Asian stock options are more cost effective than traditional stock options and provide stronger incentives to increase stock price. More importantly, the improvement is achieved with little impact on the option grant’s risk incentives (after adjusting for option cost). Finally, averaging also improves the value and incentive effects of indexed stock options.     

Optimal strike prices of stock options for effort-averse executives

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy [Hall, Brian, Murphy, Kevin J., 2000. Optimal exercise prices for executive stock options. American Economic Review 90 (2), 209–214] claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort-averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages, options, and stock grants. We simulate the manager’s effort choice and compensation as well as the value of shareholders’ equity under alternative compensation schemes, and identify schemes that are optimal. Our simulations indicate that, when abstracting from tax considerations, it is optimal to award managers with options that will most likely be highly valuable (i.e., substantially in-the-money) on their expiration date. Prior to 2006, the tax code and financial reporting standards provided incentives to award options that are closer to the money when issued than the options that were optimal in the absence of these considerations. Recent tax and reporting changes voided these incentives and thus we predict that these changes will induce firms to issue options with lower strike prices than those that were issued prior to 2006.     

Taxation and executive compensation: Evidence from stock options

Understanding the effects of taxes on executive compensation provides insight into the process determining this compensation and is a key input to top income tax rate policy. A 2010 tax reform in Canada, which greatly increased the effective tax rate on stock option compensation for a subset of firms, provides a natural experiment with which to address this issue. Difference-in-differences estimates suggest that this tax increase resulted in an immediate reduction in both stock option grants and the fraction of total compensation made up of stock options with limited, if any, substitution towards other components of compensation.