The Effect of CEO Stock Option Grants on Shareholder Return

Stock options give a corporate executive the right to purchase his or her employer's stock at a pre-set amount called the exercise or strike price. The executive's wealth increases to the extent that the market price exceeds the strike price at the time the option is exercised. Stock option compensation has received a great deal of attention from academic researchers, the business press, the Securities and Exchange Commission, the Financial Accounting Standards Board, and the general public (Business Week, 1998; Financial Accounting Standards Board, 1995; Jensen and Murphy, 1990; Securities and Exchange Commission, 1992, 1993; Yermack, 1995). Stock options offer benefits to shareholders by linking the executive's wealth to shareholder returns (Jensen and Meckling, 1976; Haugen and Senbet, 1981; Jensen and Murphy, 1990). Stock options also suffer from defects that limit their usefulness as a means for aligning the incentives of management with the interests of shareholders (Crystal, 1992). A controversy has developed around the question of whether or not the costs of stock option compensation outweigh the benefits. Despite numerous academic studies of stock option compensation, the empirical evidence is inconclusive (Yermack, 1995). If the benefits of stock option compensation outweigh the costs, then grants of CEO stock options should lead to increases in shareholder returns. If the costs of stock options outweigh the benefits, then grants will not lead to increased returns. The purpose of this study is to investigate the effect of CEO stock option grants on shareholder returns. BACKGROUND AND HYPOTHESES Benefits of Stock Option Compensation The arguments in favor of stock option compensation are based on the separation of ownership and control in the typical, large publicly-held corporation. The separation of corporate ownership and control has been a focus of research interest since the classic study by Berle and Means (1932). Jensen and Meckling (1976) couched this issue in terms of agency theory. Managers (agents) are employed to act in the best interests of shareholders (principals). Shareholders seek the maximum financial return from their investment in the corporation, but managers also value the nonfinancial perquisites of their positions with the firm. Managers who own less than one-hundred percent of the firm have both the incentive and the opportunity to consume nonfinancial perquisites in excess of the amount that would maximize the wealth of shareholders. The divergence of preference and information asymmetries between managers and shareholders create a classic agency-based conflict of interest. Granting stock options to executives can reduce these agency problems (Haugen and Senbet, 1981; Jensen and Murphy, 1990). Before the award of options is made, management will have incentives to produce the performance-based results required to earn the option grant. After the options have been granted, management will hold a larger equity stake in the firm. In both cases, the options serve to align the incentives of management with the interests of shareholders. Costs of Stock Option Compensation Crystal (1992) exemplifies the argument that the costs associated with stock options outweigh the benefits. Crystal observed that CEOs get paid "hugely in good years" and "merely wonderfully in bad years" (1992:31). There are three reasons why stock options compensation has contributed to this result: (1) stock options have upside benefits to the CEO with only minimal downside risk, (2) the value of the stock options depends on several factors beyond the control of management, and (3) corporations are not required to charge stock option compensation expense against net income. Each of these issues is discussed below. Upside Benefits versus Downside Risks. If the market price is higher than the strike price, the executive can exercise the option, immediately sell the stock, and realize a cash gain equal to the excess of the market price over the strike price. …