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Optimal strike prices of stock options for effort-averse executives

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  • Palmon, Oded
  • Bar-Yosef, Sasson
  • Chen, Ren-Raw
  • Venezia, Itzhak

Abstract

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy [Hall, Brian, Murphy, Kevin J., 2000. Optimal exercise prices for executive stock options. American Economic Review 90 (2), 209-214] claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort-averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages, options, and stock grants. We simulate the manager's effort choice and compensation as well as the value of shareholders' equity under alternative compensation schemes, and identify schemes that are optimal. Our simulations indicate that, when abstracting from tax considerations, it is optimal to award managers with options that will most likely be highly valuable (i.e., substantially in-the-money) on their expiration date. Prior to 2006, the tax code and financial reporting standards provided incentives to award options that are closer to the money when issued than the options that were optimal in the absence of these considerations. Recent tax and reporting changes voided these incentives and thus we predict that these changes will induce firms to issue options with lower strike prices than those that were issued prior to 2006.

Suggested Citation

  • Palmon, Oded & Bar-Yosef, Sasson & Chen, Ren-Raw & Venezia, Itzhak, 2008. "Optimal strike prices of stock options for effort-averse executives," Journal of Banking & Finance, Elsevier, vol. 32(2), pages 229-239, February.
  • Handle: RePEc:eee:jbfina:v:32:y:2008:i:2:p:229-239
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    References listed on IDEAS

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    Cited by:

    1. Cuñat, Vicente & Guadalupe, Maria, 2009. "Executive compensation and competition in the banking and financial sectors," Journal of Banking & Finance, Elsevier, vol. 33(3), pages 495-504, March.
    2. Dietl, Helmut M. & Grossmann, Martin & Lang, Markus & Wey, Simon, 2013. "Incentive effects of bonus taxes in a principal-agent model," Journal of Economic Behavior & Organization, Elsevier, vol. 89(C), pages 93-104.
    3. Raviv, Alon & Sisli-Ciamarra, Elif, 2013. "Executive compensation, risk taking and the state of the economy," Journal of Financial Stability, Elsevier, vol. 9(1), pages 55-68.
    4. Wu, Yan Wendy, 2011. "Optimal executive compensation: Stock options or restricted stocks," International Review of Economics & Finance, Elsevier, vol. 20(4), pages 633-644, October.
    5. Sun, Jerry & Cahan, Steven F. & Emanuel, David, 2009. "Compensation committee governance quality, chief executive officer stock option grants, and future firm performance," Journal of Banking & Finance, Elsevier, vol. 33(8), pages 1507-1519, August.
    6. Andrikopoulos, Andreas, 2009. "Irreversible investment, managerial discretion and optimal capital structure," Journal of Banking & Finance, Elsevier, vol. 33(4), pages 709-718, April.
    7. Martin Widdicks & Jinsha Zhao, 2014. "A Model of Equity Based Compensation with Tax," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 41(7-8), pages 1002-1041, September.
    8. Jean Canil & Bruce Rosser, 2015. "Evidence on exercise pricing in CEO option grants in two countries," Annals of Finance, Springer, vol. 11(3), pages 383-410, November.
    9. Len, Angel & Vaello-Sebasti, Antoni, 2009. "American GARCH employee stock option valuation," Journal of Banking & Finance, Elsevier, vol. 33(6), pages 1129-1143, June.
    10. Simona Catuogno & Sara Saggese & Fabrizia Sarto & Riccardo Viganò, 2016. "Shedding light on the aim of stock options: a literature review," Journal of Management & Governance, Springer;Accademia Italiana di Economia Aziendale (AIDEA), vol. 20(2), pages 387-411, June.

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