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Estimating the Cost of Executive Stock Options: Evidence from Switzerland

  • Wolfgang Drobetz
  • Pascal Pensa
  • Markus M. Schmid

    (University of Basel)

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    It is often argued that Black-Scholes (1973) values overstate the subjective value of stock options granted to risk-averse and under-diversified executives. We construct a “representative” Swiss executive and extend the certainty- equivalence approach presented by Hall and Murphy (2002) to assess the value-cost wedge of executive stock options. Even with low coefficients of relative risk aversion, the discount can be above 50% compared to the Black-Scholes values. Regression analysis reveals that the equilibrium level of executive compensation is explained by economic determinant variables such as firm size and growth opportunities, whereas the managers’ pay-forperformance sensitivity remains largely unexplained. Firms with larger boards of directors pay higher wages, indicating potentially unresolved agency conflicts. We reject the hypothesis that cross-sectional differences in the amount of executive pay vanish when risk-adjusted values are used as the dependent variable.

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    Paper provided by Faculty of Business and Economics - University of Basel in its series Working papers with number 2007/17.

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    Date of creation: 2007
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    Handle: RePEc:bsl:wpaper:2007/17
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