Executive Options with Inflated Equity Prices

Abstract

This study solves the optimal managerial compensation problem when shareholders are either naively optimistic or rational. The results suggest that boards of directors should decrease option grants to CEOs when equity is likely to be irrationally overvalued at the date when the CEO’s options vest. The implications of the model are consistent with the available empirical evidence. In addition, the model generates new testable predictions about managerial stock price manipulation, the number of options granted, and the magnitude of the options’ strike prices that have not yet been formally tested.