Optimal Exercise Prices For Executive Stock Options
Brian J. Hall
NOM Unit Head, Harvard Business School; National Bureau of Economic Research (NBER)
Kevin J. Murphy
University of Southern California - Marshall School of Business; University of Southern California - Department of Economics; USC Gould School of Law
Harvard NOM Working Paper No. 99-01
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.
Number of Pages in PDF File: 15
JEL Classification: J44, G13working papers series
Date posted: June 16, 2000
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