Optimal Exercise of Executive Stock Options and Implications for Firm Cost

Abstract

Options have become a major component of corporate compensation. Their cost to firms depends on the exercise policies of executives who face hedging constraints. This paper analyzes the optimal policy and option cost for an executive with general concave utility. We show analytically how the policy and cost vary with risk aversion, wealth, and dividend, and when there exists a single stock price boundary. We also provide an example with a split continuation region, and numerical results on volatility and beta effects. Option value decreases with risk aversion, increases with wealth and hedging opportunities, but can actually decline with volatility.

Keywords: Employee stock option, risk aversion, option exercise