Exercise Price Of Options Research Articles

Optimal Executive Compensation: Stock Options or Restricted Stocks

This paper develops an agency model to analyze the optimality of executive stock option compensation in the presence of information manipulation. The analyses show that although information manipulation is positively related to the size of option compensation, the relative size of manipulation-to-effort does not depend on the size of option compensation. Furthermore, an optimal executive compensation package includes stock options instead of restricted stocks under most circumstances. Testable predictions on the relationship between optimal option exercise price and exogenous model parameters are derived.

An Examination of the Accuracy and Usefulness of Management Earnings Guidance Around Stock Option Grants

The exercise price of stock options is typically the closing stock price on the option grant dates, so managers can potentially benefit from low stock prices on those dates. Prior studies find that on average, managers issue more pessimistic guidance before than after grant dates. They interpret this asymmetric pattern as representing managers’ opportunistic behavior. Nevertheless, it is not clear whether this pattern reflects managers’ selective timing of bad news disclosures or a deliberate misrepresentation of underlying firm performance. This paper extends the literature by examining the effects of managerial stock option incentives on the accuracy and the information content of firms’ voluntary earnings guidance. We find that pre-grant guidance significantly improves existing consensus earnings forecasts, and is similar in bias and accuracy to post-grant guidance. Moreover, investors and analysts react similarly to pre-grant vs. post-grant guidance, suggesting that the main consumers of earnings guidance view these two types of guidance to be equally informative. Our results are consistent with the notion that managers may opportunistically select the type or the timing of disclosures, but when they opt to disclose, they do not misrepresent the underlying firm performance. On the contrary, the seemingly opportunistic guidance before option grants improves overall firms’ information environment, because it is at least as truthful and informative as post-grant guidance, and is issued more frequently than by managers who do not have incentives to report bad news before earnings announcements.

The Effect of the Sarbanes-Oxley Act on the Timing Manipulation of CEO Stock Option Awards

Section 403 of the Sarbanes-Oxley Act accelerates the reporting deadline of executive stock option grants to be within two business days after the grants. This study investigates the effect of Section 403 on the extent of CEO influence over grant date stock prices aimed at enhancing the value of executive stock option awards. Prior studies find that executives affect the exercise price of options by influencing the timing of option awards, manipulating the timing of value-relevant information around option awards, or backdating the award in an attempt to lower the grant date stock price, thereby increasing the value of their options. We find that the accelerated reporting requirement of SOX 403 significantly reduces CEO influence over grant date stock prices in the post-SOX period. Specifically, we find that the accelerated reporting requirement (1) deters the opportunistic granting of unscheduled awards after bad news announcements and reduces, but does not eliminate, the opportunistic granting of unscheduled awards before good news announcements; (2) deters the delaying of good news announcements after scheduled option awards; and (3) greatly reduces the apparent use of backdating of option grants to lower the strike price. Thus, we provide important new evidence on the economic impact of SOX on mitigating executive opportunistic behavior associated with stock option grants.

The Timing of CEO Stock Option Grants: Scheduled versus Unscheduled Awards

This study seeks to provide insights into companies' decisions to issue stock options to CEOs on a scheduled or an unscheduled basis. We first document that unscheduled option awards provide CEOs with greater flexibility to influence the grant date stock price that leads to a lower exercise price of options and a higher accreted value realized at exercise. We then investigate whether the choice between unscheduled and scheduled awards is affected by the degree of CEO influence and the importance of stock options in CEO compensation. Consistent with expectations, we find that firms with greater CEO influence over compensation committees and boards and firms with greater use of stock options in CEO compensation are more likely to issue options to CEOs on an unscheduled basis. We also examine whether compensation committees and boards are effective in limiting CEOs' option timing manipulation for unscheduled awards and information timing manipulation for scheduled option awards. We find that, for firms that issue unscheduled options, boards that are less independent of management and that receive a greater proportion of director compensation from stock options allow greater management opportunism with respect to the timing of option awards. In contrast, for firms that issue scheduled options, we find no significant impact of board independence and director option compensation on the extent of management opportunism with respect to the timing of information releases around option awards.

How to use Stock and Stock Options for Interest Alignment: Managerial Investment Behavior and Portfolio Considerations

This paper analyzes theoretically the effect of stock and stock options on the investment behavior of managers. Recent theoretical results state that stock options are an inefficient means of motivating managerial effort. But if the manager holds restricted stock and is allowed to invest his non-firm related wealth in the market portfolio and the riskless asset, he will pass up positive net present value projects since he cannot diversify the firm-specific risk. The paper analyzes if and how this investment incentive problem can be mitigated by issuing stock options. In case options are used alternatively to stock, we find that for every positive exercise price lower than a critical level, there exists a unique number of options to induce the desired investment behavior if the manager does not hold any stock. The relation between exercise price and number of options issued is positive. Though, if the manager holds both stock and options, options with low exercise prices can no longer mitigate the underinvestment problem. In contrast, for exercise prices sufficiently large to eliminate the underinvestment incentives and a given number of stock, there are a small and a large number of options to induce the desired investment behavior. Since recent theoretical contributions have called into question the efficiency of stock options in motivating managerial effort compared to restricted stock, this paper can make a contribution concerning the prevalence of stock options in executive compensation. A numerical analysis completes the paper and underlines the relevance of the theoretical results.

Leverage, volatility and executive stock options

This paper studies how an optimal wage contract can be implemented using stock options, and derives the properties of the optimal contract with stock options. Specifically, we show how the exercise price and the size of the option grant should change in response to changes in exogenous parameters. First, for a fixed exercise price of executive stock options, the size of the option grant decreases in the riskiness of a desired investment policy, decreases in the volatility of return from the risky project, and increases in leverage. Second, for a fixed size of the option grant, the optimal exercise price of managerial stock options increases in the riskiness of a desired investment policy, increases in the volatility of return from the risky project, and decreases in leverage. Several empirical predictions are drawn from these conclusions regarding the pay-performance sensitivity of management compensation.

Rescission and Repricing of Executive Stock Options

We examine the ex-ante optimality of repricing and rescission of executive stock options while considering dilution effects and the tax effects of new accounting rules associated with repricing and rescission. Repricing lowers the exercise price of outstanding options to match the declined market value of the stock and rescission allows employees to cancel already-exercised options when share prices fall. Although there has been a body of literature on repricing by using pre-1998 data, the possible optimality of traditional repricing after considering the economic impact of changing accounting rules has not been addressed in an ex-ante contracting setting. Our paper serves that purpose. Meanwhile, we note that there has been little empirical or analytical research conducted on rescission, which was not an issue until 2000 when the stock market plummeted. The theoretical predictions of our paper shed some light on these controversial practices. We show that repricing loses its ex-ante dominance over the do-nothing strategy, as claimed by Acharya, John, and Sundaram (2000), after we incorporate dilution effects and the tax effects of new accounting rules associated with repricing. Taking effect in July 2000 and retroactive to December 15, 1998, those accounting rules forced companies to take a variable charge to earnings for repriced options. The variable charges, as opposed to one-time fixed costs, require companies to mark-to-market all repriced options in each quarterly earnings report. As a result, repricing is about equal to do-nothing in terms of the principal's (or shareholders') expected initial payoffs. On the other hand, the principal will be almost always better off in terms of expected initial payoffs under rescission than under the do-nothing policy if he/she takes the tax benefit and cash flows resulting from the option exercises into account and designs the initial option contract accordingly. Hence, given the new accounting rulings, rescission can still be an important and value-enhancing strategy from an ex-ante standpoint in our two-period model. Overall, the combined impact of dilution effects and tax effects on ex-ante contracting decision is economically significant.

Step‐reset options: Design and valuation

AbstractThis study proposes a new design of reset options in which the option's exercise price adjusts gradually, based on the amount of time the underlying spent beyond prespecified reset levels. Relative to standard reset options, a step‐reset design offers several desirable properties. First of all, it demands a lower option premium but preserves the same desirable reset attribute that appeals to market investors. Second, it overcomes the disturbing problem of delta jump as exhibited in standard reset option, and thus greatly reduces the difficulties in risk management for reset option sellers who hedge dynamically. Moreover, the step‐reset feature makes the option more robust against short‐term price movements of the underlying and removes the pressure of price manipulation often associated with standard reset options.To value this innovative option product, we develop a tree‐based valuation algorithm in this study. Specifically, we parameterize the trinomial tree model to correctly account for the discrete nature of reset monitoring. The use of lattice model gives us the flexibility to price step‐reset options with American exercise right. Finally, to accommodate the path‐dependent exercise price, we introduce a state‐to‐state recursive pricing procedure to properly capture the path‐dependent step‐reset effect and enhance computational efficiency. © 2002 John Wiley & Sons, Inc. Jrl Fut Mark 22:155–171, 2002

Do Underwater Executive Stock Options Still Align Incentives? The Effect of Stock Price Movements on Managerial Incentive-Alignment

The concern that out-of-the-money stock options are not an effective way to motivate managers has led boards of directors to consider measures such as lowering the exercise price of underwater options, or issuing new option grants, to restore the incentive managers have to increase shareholder value. This paper explores whether such measures are needed: do out-of-the-money options lose their power to align incentives? We address this question by estimating how the incentive-alignment power of options changed over the course of the year 2000, a year that for many firms marked the derailment of the long-running bull stock market. Examining the sensitivity in the value of the manager's stock option to changes in the firm's stock price (one metric for incentive-alignment power), we find that in general the ability of options to align incentives remained remarkably intact. This resilience in incentive-alignment power stems from the long maturity of executive stock options, the relatively high stock price volatility of firms that experienced stock price declines, and to a lesser extent, the increase in volatility levels that accompanied weakening stock prices. We test the robustness of these results to the metric of incentive-alignment power, replacing market values with the value that managers place on their stock and option holdings, adjusting for managers' inability to fully diversify their portfolios. We also test how sensitive our results are to volatility assumptions. We conclude that even a steep decline in stock price can leave incentive levels intact, so restoring incentive-alignment is seldom a good justification for resetting the stock price or issuing new option grants. Before rejecting such measures, however, boards must examine whether the ability of stock and option holdings to retain key managerial talent deteriorated as the stock price declined, for our findings suggest that in selected firms or industries, the value of those holdings declined substantially.

Leverage, Volatility and Executive Stock Options

This paper studies how an optimal wage contract can be implemented using stock options, and derives the properties of the optimal contract with stock options. Specifically, we show how the exercise price and the size of the option grant should change in respose to changes in exogenous parameter. First, for a fixed exercise price of executive stock options, the size of the option grant decreases in the riskiness of a desired investment policy, decreases in the volatility of return from the risky project, and increases in leverage. Second, for a fixed size of the option grant, the optimal exercise price of managerial stock options increases in the riskiness of a desired investment policy, increases in the volatility of return from the risky project, and decreases in leverage. Several empirical predictions are drawn from these conclusions regarding the pay-performance sensitivity of management compensation.

Cendant Corp.: A Case Study Examining the Compensation and Accounting Issues Involved in a Stock-Option Repricing Program

Stock options are usually issued to corporate executives in an attempt to align the interests of those individuals with the interests of the company's shareholders. The options are designed to provide a large payoff to the executives when the company's stock price increases substantially above the exercise price of the options. However, in those periods when a company performs poorly, its stock price may decrease to a level below the exercise price of outstanding options. When this occurs, the options are said to be “underwater.” Because options provide a benefit only as the stock price increases, underwater options will often lack the motivational incentive that they were designed to create. This creates a dilemma to the compensation committee of the company—i.e., modify the compensation agreements of the individuals in charge during the period of poor stock price performance or risk losing those executives to other companies. One such modification that is often considered in these circumstances is a stock-option repricing program. Here, underwater stock options are exchanged for new options containing a lower exercise price. These programs experienced increased popularity during the 1990s despite the opposition that arose from critics who claimed that repricing programs “rewarda” executives for poor performance. This instructional case requires students to evaluate the appropriateness of a stock-option repricing program for the executives and other employees of Cendant Corp. This company experienced a severe decrease in its stock price during 1998 as a result of many factors including an accounting scandal, failed expansion efforts, and poor market conditions. In addition, the case material can also be used to introduce students to the accounting implications of stock-option repricing programs as modified by Interpretation No. 44, issued by the Financial Accounting Standards Board in March 2000.

Maturity and exercise price of executive stock options

AbstractUsing a simple three‐period model in which a manager can gather information before making an investment decision, this paper studies optimal contracts with various stock options. In particular, we show how the exercise price of executive stock options is related to a base salary, the size of the option grant, leverage, and the riskiness of a desired investment policy. The optimal exercise price increases in the size of grant and the base salary and decreases in leverage and the riskiness of a desired investment policy. Other things equal, the optimal exercise price of European options with a longer maturity should increase more for an increase in the base salary and the size of grant and decrease more for an increase in leverage than the one with a shorter maturity. The optimal exercise price of American options is determined by the optimal exercise prices of European options with different maturities. Given the fixed exercise price, the size of the option grant does not decrease in the face value of debt.

Altering the Terms of Executive Stock Options

This paper examines the practice of resetting of the terms of previously-issued executive stock options. We identify the properties of the typical reset option, characterize the firms that have reset options, and develop a model to value options that may be reset. In our sample of 396 executives whose options had terms reset in the 1992-95 period, a large majority ad exercise prices reset to the market price. This resulted in a reduction of the typical option's exercise price by about 40%. Slightly less than half of these options also had their maturities extended, generally receiving a new expiration of 10 years. We find that resetting has a strong negative relationship with firm performance even after correcting for industry performance. Resetting is also significantly more common among small firms than among large firms. However, few other industry- or firm-specific factors appear to matter. Finally, we find that the possibility of resetting does not have a large impact on the ex-ante value of an option award, but the ex-post gain can be substantial.

Executive Stock Options and the Mediation of Stockholder-Bondholder Conflicts

Financial leverage does not distort investment decisions if executives are paid to maximize total firm value rather than equity value. Existing models of this idea imply that stock-based incentives should be negatively related to firm leverage, a prediction that has little empirical support. We show that the risk distortions induced by financial leverage can be overcome without diluting effort incentives by adjusting the exercise price of executive stock options. We also show that the necessary adjustments are similar to the common practice of granting options at-the-money. We then empirically examine the risk incentives of executive stock option plans in a large sample of Canadian firms. The evidence consistently supports the hypothesis that executive stock options mitigate the risk-taking incentives of shareholders in levered firms.

Instant Option Betas

An investor considering the addition of options to his investment portfolio must consider the effect an option will have on portfolio risk. The 'eta of an option at any point in time can be calculated from the beta of its underlying stock and the option 's risk elasticity-a measure of the percentage change in the value of the option for a small percentage change in the value of the underlying stock. An option's beta will change in a predictable fashion with changes in the underlying stock's price and variance rate, the option's exercise price and time to expiration, and the risk-free interest rate. A call option's beta will decrease with increasing stock price and exercise price and increase with an increasing risk-free rate; its sensitivity to variance and time to expiration will depend on the stock price to exercise price ratio. Nomograms provide a quick and easy way to estimate option betas from these readily observable underlying parameters. Option betas will also change, often drastically, with the passage of time. Graphs indicate that, in general, call betas will increase as time to expiration increases. The ultimate impact will depend, however, on the parameters of the contract and on changes in the underlying stock's price.