Optimal Exercise Prices for Executive Stock Options

16 Pages Posted: 27 Jul 2000 Last revised: 16 Oct 2010

See all articles by Brian J. Hall

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; USC Gould School of Law

Multiple version iconThere are 3 versions of this paper

Date Written: February 2000

Abstract

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.

Suggested Citation

Hall, Brian and Murphy, Kevin J., Optimal Exercise Prices for Executive Stock Options (February 2000). NBER Working Paper No. w7548. Available at SSRN: https://ssrn.com/abstract=235468

Brian Hall (Contact Author)

NOM Unit Head, Harvard Business School ( email )

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Kevin J. Murphy

University of Southern California - Marshall School of Business ( email )

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USC Gould School of Law

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