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Managing Option Fragility

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  • Brian J. Hall
  • Thomas A. Knox

Abstract

We analyze and explore option fragility, the notion that option incentives are fragile due to their non-linear payoff structure. Option incentives become weaker as options fall underwater, leading to pressures to reprice options or restore incentives through additional grants of equity-based pay. We build a detailed data set on executives' portfolios of stock and options and find that executive options are frequently underwater, even when average stock returns have been high. For example, at the height of the bull market in 1999, approximately one-third of all executive options were underwater. We find that, in contrast to the incentives provided by stock, the incentives provided by options are quite sensitive to stock price changes, especially on the downside. Overall, we find that the incentives created by all executive holdings have an elasticity with respect to stock price decreases of about 0.7, and this elasticity is larger for high-option executives and for executives with high percentages of options already underwater. The dominant mechanism through which companies manage option fragility is larger option grants following stock price declines; on average, these larger grants restore approximately 40% of the stock-price-induced incentive declines. Option repricings are far less prevalent, despite the attention they have garnered. Interestingly, we find that for positive stock returns, higher returns lead to larger option grants, which raise incentives further. Thus, option grants are largest when companies do very poorly or very well. Executive exercising behavior also affects option fragility. Since executives are much less likely to exercise options following stock price decreases, the natural declines in incentives due to exercises are attenuated on the downside, leading executives to 'manage their own incentives' in a way that augments company management of option fragility.

Suggested Citation

  • Brian J. Hall & Thomas A. Knox, 2002. "Managing Option Fragility," NBER Working Papers 9059, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:9059
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    References listed on IDEAS

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    Cited by:

    1. Brian J. Hall, 2003. "Six Challenges in Designing Equity-Based Pay," NBER Working Papers 9887, National Bureau of Economic Research, Inc.
    2. Sircar, Ronnie & Xiong, Wei, 2007. "A general framework for evaluating executive stock options," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2317-2349, July.
    3. Brian J. Hall & Kevin J. Murphy, 2003. "The Trouble with Stock Options," Journal of Economic Perspectives, American Economic Association, vol. 17(3), pages 49-70, Summer.
    4. Benson, Bradley W. & Davidson III, Wallace N., 2009. "Reexamining the managerial ownership effect on firm value," Journal of Corporate Finance, Elsevier, vol. 15(5), pages 573-586, December.
    5. Wei Xiong & Ronnie Sircar, 2004. "Evaluating Incentive Options," Econometric Society 2004 North American Winter Meetings 253, Econometric Society.
    6. Bettis, J. Carr & Bizjak, John M. & Lemmon, Michael L., 2005. "Exercise behavior, valuation, and the incentive effects of employee stock options," Journal of Financial Economics, Elsevier, vol. 76(2), pages 445-470, May.
    7. Paul M. Healy & Krishna G. Palepu, 2003. "The Fall of Enron," Journal of Economic Perspectives, American Economic Association, vol. 17(2), pages 3-26, Spring.
    8. Kose John & Hamid Mehran & Yiming Qian, 2007. "Regulation, subordinated debt, and incentive features of CEO compensation in the banking industry," Staff Reports 308, Federal Reserve Bank of New York.
    9. repec:wsi:qjfxxx:v:01:y:2011:i:01:n:s2010139211000055 is not listed on IDEAS

    More about this item

    JEL classification:

    • J3 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs
    • G3 - Financial Economics - - Corporate Finance and Governance

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