Executive Stock Options

Abstract

The structure that has been given to this article is the following.In Section 2, the economic reasons for granting options to executives are outlined.In Section 3 some information is given on the quantitative importance of the phenomenon, with particular reference to the overhang - defined as the ratio between the number of shares underlying the stock options (already granted or to be granted) and the number of outstanding shares. In Section 4 the main features of executive stock options are described, in order to highlight the differences with respect to ordinary options: performance-based grants, vesting requirements, non-transferability, repricing, etc.. The implications of these features for hedging and exercise strategies, the effects on firms' net worth and distributive policies are also examined. The advantages of indexed stock options, i.e. options whose strike changes as a function of a market or a sector index, are discussed and the opinion of Alan Greenspan on this subject is reported.Section 5 examines the properties of the valuation schemes proposed in the last thirty years: from the simple solutions of Smith and Zimmermann (1976) and Jennergren and Naslund (1993) to the models of Huddart (1994), Kulatilaka and Marcus (1994), Rubinstein (1995), Ingersoll (2002), Hull and White (2002a,b).Special attention is paid to the ESO valuation model built by Ingersoll. This emphasis is justified by the theoretical solidity of the model, which has its roots in the classical analysis of Merton (1969) for the optimal lifetime selection of consumption and investment. The Ingersoll model makes it possible not only to determine the market and subjective values of stock options, but also to estimate their objective value, that is the value from the standpoint of the firm which issued them. This value - which corporations will have to show in their P&L accounts starting in 2005 - must be determined taking into account the fact that the stock-option holders are constrained - because of options' non-transferability - to follow an exercise strategy which is sub-optimal from a market standpoint.Section 5 ends with a discussion of a recent paper by Hull & White (2002a,b) and with a comparison between the results obtained following Hull & White and those obtained using the Ingersoll model. Some short conclusions are added.