Optimal Exercise Prices for Executive Stock Options

Posted: 26 Jun 2001

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

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.

JEL Classification: J44, G13

Suggested Citation

Hall, Brian and Murphy, Kevin J., Optimal Exercise Prices for Executive Stock Options. American Economic Review, May 2000. Available at SSRN: https://ssrn.com/abstract=261020

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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