Optimal Strike Prices of Stock Options for Effort Averse Executives

33 Pages Posted: 1 Jul 2004

See all articles by Oded Palmon

Oded Palmon

Rutgers Business School

Sasson Bar-Yosef

Hebrew University

Ren-Raw Chen

Fordham University - Gabelli School of Business

Itzhak Venezia

Hebrew University of Jerusalem - Jerusalem School of Business Administration

Date Written: March 15, 2004

Abstract

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy, 2000, claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages and options or stock grants. We simulate the firm's decisions and the manager's effort choice under alternative compensation schemes and identify schemes that are optimal. Our simulations indicate that when abstracting from tax considerations, it is optimal to establish the strike price in-the-money. However, when issuing in the money options creates tax related disadvantages, it may be optimal to issue at-the-money options. We show that the above result holds both in the case when the strike price is linked to an economy-wide benchmark and when it is not benchmarked. Our simulations also indicate that issuing options with benchmarked strike prices usually dominates issuing options with non-benchmarked strike prices.

Suggested Citation

Palmon, Oded and Bar-Yosef, Sasson and Chen, Ren-Raw and Venezia, Itzhak, Optimal Strike Prices of Stock Options for Effort Averse Executives (March 15, 2004). EFA 2004 Maastricht Meetings Paper No. 1425. Available at SSRN: https://ssrn.com/abstract=559922 or http://dx.doi.org/10.2139/ssrn.559922

Oded Palmon

Rutgers Business School ( email )

Room 5123
100 Rockafeller Road
Piscataway, NJ 08854
United States
848-445-4209 (Phone)
848-445-3907 (Fax)

Sasson Bar-Yosef

Hebrew University ( email )

Mount Scopus
Jerusalem, IL Jerusalem 91905
Israel

Ren-Raw Chen

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
Bronx, NY 10458
United States

Itzhak Venezia (Contact Author)

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel

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