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The Subjective and Objective Evaluation of Incentive Stock Options

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  • Jonathan Ingersoll
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    Abstract

    Incentive options are held by managers and employees who invariably hold undiversified portfolios with substantial amounts invested in their own company's common stock. This lack of diversification makes the subjective value of incentive items such as options less than their market value. This paper derives a model for the marginal value of such options or other incentive items. As such, it can be used to evaluate heterogeneous options which mature on different dates. It can also be used each time a new option is granted. The identical model (with different parameters)can be used to determine three different values for each option, the market value, the subjective value and the objective values. The market value is the value the option would have if it were held by an unconstrained agent. The subjective value - the value of the holder - is less than the market value because the option is held in an undiversified portfolio and because it is exercised suboptimally from the market perspective. The objective value is the cost to the firm of issuing the option and lies between the market and subjective values. This value recognizes the suboptimal exercise but not the undiversified discount. The model is no more difficult to use than is the Black- Scholes model. In fact, under the same conditions, it is simply the Black-Scholes model with modified

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    Bibliographic Info

    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm276.

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    Date of creation: 01 Apr 2002
    Date of revision: 01 Jul 2003
    Handle: RePEc:ysm:somwrk:ysm276

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    1. Huddart, Steven & Lang, Mark, 1996. "Employee stock option exercises an empirical analysis," Journal of Accounting and Economics, Elsevier, vol. 21(1), pages 5-43, February.
    2. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
    3. Johnson, Shane A. & Tian, Yisong S., 2000. "The value and incentive effects of nontraditional executive stock option plans," Journal of Financial Economics, Elsevier, vol. 57(1), pages 3-34, July.
    4. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 653-691, August.
    5. Carpenter, Jennifer N., 1998. "The exercise and valuation of executive stock options," Journal of Financial Economics, Elsevier, vol. 48(2), pages 127-158, May.
    6. Paul André & M. Martin Boyer & Robert Gagné, 2002. "Do CEOs Exercise Their Stock Options Earlier than Other Executives?," CIRANO Working Papers 2002s-71, CIRANO.
    7. Menachem Brenner & Rangarajan K. Sundaram & David Yermack, 1998. "Altering the Terms of Executive Stock Options," New York University, Leonard N. Stern School Finance Department Working Paper Seires 98-010, New York University, Leonard N. Stern School of Business-.
    8. Jennifer N. Carpenter, 2000. "Does Option Compensation Increase Managerial Risk Appetite?," Journal of Finance, American Finance Association, vol. 55(5), pages 2311-2331, October.
    9. Ingersoll, Jonathan E, Jr, 2000. "Digital Contracts: Simple Tools for Pricing Complex Derivatives," The Journal of Business, University of Chicago Press, vol. 73(1), pages 67-88, January.
    10. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
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    Cited by:
    1. Marc Chesney & Rajna Gibson, 2008. "Stock options and managers’ incentives to cheat," Review of Derivatives Research, Springer, vol. 11(1), pages 41-59, March.
    2. Bergman, Nittai K. & Jenter, Dirk, 2007. "Employee sentiment and stock option compensation," Journal of Financial Economics, Elsevier, vol. 84(3), pages 667-712, June.
    3. Elettra Agliardi & Rainer Andergassen, 2005. "Incentives of Stock Option Based Compensation," Review of Quantitative Finance and Accounting, Springer, vol. 25(1), pages 21-32, August.

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