Too Much of a Good Incentive? The Case of Executive Stock Options
34 Pages Posted: 27 Apr 2005
Using a utility-maximization framework, I show that the incentive to increase stock price does not always increase as more options are granted. Keeping the total cost of his compensation fixed, granting more options creates greater incentives to increase stock price only if option wealth does not exceed a certain fraction of total wealth. Beyond this critical level, granting more options actually reduces incentive effects and becomes counterproductive. In addition, stock options also create incentive to reduce (increase) idiosyncratic (systematic) risk. These incentive effects are sensitive to the choice of exercise price.
Keywords: Executive stock options, executive compensation, Incentives, risk aversion, certainty equivalent value
JEL Classification: G11, G13, G30, J33, M52
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