Stock Options for Undiversified Executives
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
NBER Working Paper No. w8052
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.
Number of Pages in PDF File: 51working papers series
Date posted: March 7, 2001
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