Revisiting the incentive effects of executive stock options

Abstract

We develop a multiperiod framework to evaluate the incentive effects of executive stock options (ESOs). For a given increase in the grant-date firm stock price (and a concurrent increase in return volatility), the increment of total value at the vesting date acts as a proxy for the incentive effects of ESOs. If the option is attached to the existing contract without adjusting cash compensation, we suggest that a firm should not always fix the strike price to the grant-date stock price; instead, the strike price should vary with the length of the vesting period. We also show that, compared with at-the-money options, restricted stock generates greater incentives to increase stock prices in some scenarios, especially when equity-based awards are vested early. If the vesting period is long, the firm could grant options instead of restricted stock to maximize incentives.