It is a widely accepted result that executives usually value stock options at lower than market values. Hall and Murphy (2002) argue that executives are undiversified and risk averse, so they value their stock options at lower than market values. In addition, they also argue that stock options are inefficient relative to restricted stock because of the lower sensitivity of option values to the change in stock prices. Moreover, Meulbroek (2001) argues that executives bear more than the optimal level of firm-specific risk and, therefore, require a higher risk premium.
These arguments have some explanatory power for low executive option values, and these factors affect substantially the incentives of stock options. Hall (2003), however, mentions that one of the striking features of executive pay during the previous two decades is the remarkable increase in the use of stock options. As shown in Figure 1, the percentage of stock options in median executive compensation increased dramatically from 1992 to 2000. After 2000, options still account for more than 40% of executive pay. Accordingly, one interesting question is why most companies still use stock options to compensate their executives if stock options have low option values and are as inefficient as argued in the literature. We propose one possible answer that managerial ability, which reflects both managerial effort and quality, increases the attractiveness of stock options to managers.
Jensen and Meckling (1976) point out the conflict of interests between managers and shareholders, which is well known as the agency problem or principal-agent problem. Some researchers, such as Grossman and Hart (1983), attempt to resolve this problem through the theory of optimal contracts. In the principals’ maximization problem, there is an incentive compatibility constraint. That is, optimal contracts should incentivize managers to exert optimal effort to maximize shareholder wealth. Even though managerial ability is a key factor in these contracts, it is ignored in many academic papers on executive compensation. Lambert and Larcker (2004) and Feltham and Wu (2001) mention a similar problem in the literature, and they argue that incentive effects should be considered in the evaluation of stock-based compensation.
CONTENTS
ACKNOWLEDGEMENTS
LIST OF TABLES
LIST OF FIGURES
ABSTRACT
CHAPTER 1. INTRODUCTION
CHAPTER 2. LITERATURE REVIEW
- 2.1 Theoretical Literature
2.2 Empirical Literature
CHAPTER 3. THEORETICAL MODEL
- 3.1 Determination of Optimal Effort
- 3.1.1 Discrete Time Model
3.1.2 Continuous Time Model
3.2 Executive Option Values
3.3 Early Exercise
3.4 Parameter Setting
- 3.4.1 Black-Scholes Variables
3.4.2 CAPM Variables
3.4.3 Managerial Properties
CHAPTER 4. SIMULATION RESULTS
- 4.1 Optimal Managerial Effort
4.2 Option Values
4.3 Restricted Stock
4.4 Early Exercise
CHAPTER 5. IMPLICATIONS AND EMPIRICAL TESTS
- 5.1 Testable Implication and Hypothesis
5.2 Empirical Analysis
- 5.2.1 Data Description
5.2.2 Regression of Abnormal Return
5.2.3 Summary of the Issues Related to Executive Compensation
5.2.4 Pay-for-Performance Sensitivity
CHAPTER 6. CONCLUSION AND FUTURE RESEARCH
- 6.1 Conclusion
6.2 Future Research
REFERENCES
APPENDIX
- I: THE COMPUTATION OF OPTIMAL EFFORT AND EXECUTIVE OPTION VALUE
II: ILLUSTRATION OF THE TRADE-OFF BETWEEN EXERCISE PRICE AND THE PROBABILTY OF
AN OPTION EXPIRICNG IN-THE-MONEY
III: THE INTUITION OF THE USE OF CDF OF STOCK RETURN VARIANCE AND AN EXAMPLE
VITA
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