Do underwater executive stock options still align incentives?
Subtitle: the effect of stock price movements on managerial incentive-alignment
By: Li Jin, Lisa Meulbroek
Contributors: Meulbroek, Lisa K.; Harvard Business School. Division of Research
Series: Working paper / Division of Research, Harvard Business School -- 02-002; Working paper (Harvard Business School. Division of Research) -- 02-002
Publisher: Division of Research, Harvard Business School
Published: 2001
Place of publication: Boston]
Language: eng
Number of pages: 71
Description: 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 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 holding, adjusting for managers' inability to fully diversify their portfolios.
Notes: Includes bibliographical references.