Too Much of a Good Incentive? The Case of Executive Stock Options

34 Pages Posted: 27 Apr 2005

See all articles by Yisong S. Tian

Yisong S. Tian

York University - Schulich School of Business

Abstract

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

Suggested Citation

Tian, Yisong Sam, Too Much of a Good Incentive? The Case of Executive Stock Options. Journal of Banking and Finance, Vol. 28, pp. 1225-1245, June 2004. Available at SSRN: https://ssrn.com/abstract=707901

Yisong Sam Tian (Contact Author)

York University - Schulich School of Business ( email )

4700 Keele Street
Toronto, Ontario M3J 1P3
Canada
416-736-2100, ext 77943 (Phone)
416-736-5687 (Fax)

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