Designing an Option Plan that Rewards Relative Performance: Indexed Options Revisited

Harvard Business School Working Paper No. 02-022

HBS Finance Working Paper No. 02-022

66 Pages Posted: 16 Oct 2001

See all articles by Lisa K. Meulbroek

Lisa K. Meulbroek

Claremont McKenna College - Robert Day School of Economics and Finance

Date Written: October 2001

Abstract

This paper examines how an option plan that rewards managers for firm performance relative to some market or industry benchmark should be structured. Relative-performance-based compensation advocates contend that conventional stock options do not adequately discriminate between strong and weak managers, typically suggesting "indexed options," that is, options with an exercise prive linked to a market or industry index, as a remedy. A close examination of indexed options, however, reveals a fundamental problem: indexed options do not function as its proponents intend. Instead, their payoff remains highly sensitive to market or industry price movements. This paper proposes as alternative option design, an option on a "performance-benchmarked portfolio," that does remove the effects of the specified market or industry benchmark from the value of the option. This structure uses an option with a fixed exercise price, where the underlying asset is a portfolio comprised of the firm's stock hedged against market and industry price movements.

Keywords: Executive Compensation, Indexed Options, Relative-Performance-Based Compensation, Market-Adjusted Options, Stock Options

JEL Classification: G00, G30, G32, G34, J33, G13

Suggested Citation

Meulbroek, Lisa K., Designing an Option Plan that Rewards Relative Performance: Indexed Options Revisited (October 2001). Harvard Business School Working Paper No. 02-022; HBS Finance Working Paper No. 02-022. Available at SSRN: https://ssrn.com/abstract=287067 or http://dx.doi.org/10.2139/ssrn.287067

Lisa K. Meulbroek (Contact Author)

Claremont McKenna College - Robert Day School of Economics and Finance ( email )

500 E. Ninth St.
Claremont, CA 91711-6420
United States
909-607-7363 (Phone)

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