9 Pages Posted: 16 May 2005
Date Written: May 2004
The Stock Options have become one of the most commonly used instruments in the executives' compensation packages. Nevertheless, the cost to the firm of the Stock Options, usually, is much higher than its value to the executives. One of the reasons for this discrepancy is that there is no secondary market for Stock Options, which, means that it is forbidden to sell them - and additionally, the majority of the executives lack the possibility of forming a portfolio with the same payoffs and sell it. Therefore, it prevents the executives from doing arbitrage and their expectations about the evolution of the stock's prices are relevant, which in turn in the eyes of the executives further lowers the value of the Stock Option. We have developed a very simple model, in which on one side we have calculated the cost of the options to the firm by utilizing traditional formulas and on the other side we have worked with the formula Binomial but it includes a Certainty Equivalent Wealth function. We find that - depending on degree of risk aversion, the value of the option perceived by the executive is much lower than the cost that the firm bears for the same option.
Keywords: Stock options, compensation
JEL Classification: C13, J33
Suggested Citation: Suggested Citation