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Optimal Exercise Prices for Executive Stock Options

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  • Kevin J. Murphy
  • Brian J. Hall

Abstract

Although exercise prices for executive stock options can be set either below or above the grant-date market price, in practice virtually all options are granted at the money. We offer an economic rationale for this apparent puzzle, by showing that pay-to-performance incentives for risk-averse undiversified executives are typically maximized by setting exercise prices at (or near) the grant-date market price. We provide an operationally useful alternative to Black-Scholes (1973) for the purpose of both valuing executive stock options and measuring the incentives created by options. Our framework has implications not only for exercise-price policies, but also for indexed options, option repricings, exchanges of cash for stock-based compensation, and the design of bonus plans.
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Suggested Citation

  • Kevin J. Murphy & Brian J. Hall, 2000. "Optimal Exercise Prices for Executive Stock Options," American Economic Review, American Economic Association, vol. 90(2), pages 209-214, May.
  • Handle: RePEc:aea:aecrev:v:90:y:2000:i:2:p:209-214
    Note: DOI: 10.1257/aer.90.2.209
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    File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.90.2.209
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    References listed on IDEAS

    as
    1. Lambert, Ra & Larcker, Df & Verrecchia, Re, 1991. "Portfolio Considerations In Valuing Executive-Compensation," Journal of Accounting Research, Wiley Blackwell, vol. 29(1), pages 129-149.
    2. Robert C. Merton, 2005. "Theory of rational option pricing," World Scientific Book Chapters, in: Sudipto Bhattacharya & George M Constantinides (ed.), Theory Of Valuation, chapter 8, pages 229-288, World Scientific Publishing Co. Pte. Ltd..
    3. Hall, Brian J. & Murphy, Kevin J., 2002. "Stock options for undiversified executives," Journal of Accounting and Economics, Elsevier, vol. 33(1), pages 3-42, February.
    4. Brian J. Hall & Jeffrey B. Liebman, 1998. "Are CEOs Really Paid Like Bureaucrats?," The Quarterly Journal of Economics, Oxford University Press, vol. 113(3), pages 653-691.
    5. 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 637-654, May-June.
    6. O. Ashenfelter & D. Card (ed.), 1999. "Handbook of Labor Economics," Handbook of Labor Economics, Elsevier, edition 1, volume 3, number 3.
    7. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563, Elsevier.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    JEL classification:

    • M12 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - Personnel Management; Executives; Executive Compensation

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