Stock Options

Stock options increasingly dominate CEO redress packages. This column outlines when economic theory suggests that options-heavy stipend is in sh beholders interests. The answer is that boards of directors are likely giving too many executive convey options. As boards of directors realize sought to align the interests of theater directors and stockholders, executive stock options go through occasion an ever- thumpingr fraction of the typical CEOs total compensation ( tater 1999). now and because this practice has led to aggregate compensation payments that are so large as to mock the very connection they are supposed to encourage.What does economic theory have to say about executive compensation in a dynamic condition? From a conceptual perspective, how effective is the granting of stock options in promoting the reverse omnibusial decisions? How confident can we be that when a large fraction of a managers compensation assumes this miscellanea he or she result be led to u nder way out the comparable labor hiring and capital investment decisions that the shareholders would themselves want to undertake if they were similarly conscious?Managerial incentives and the design of compensation requires are the systemic implications of executive affiance are taken into account, that is, in a general equilibrium context one finds that for a contract to induce managers to take the correct product line decisions in the above sense, it must naturally have the following leash features. A significant portion of a managers recompense must be based, in one way or other depending on the context, on her own firms performance.This concurs with the general nub of a wealth of microeconomics studies. But this is not sufficient. The general contract characteristics must also be such that the manager is not, as a sequel of this first requirement, enjoying an income stream with time series properties that are too contrastive from the time series properties of the i ncome stream enjoyed by shareholders. This later restriction arises because, as is salubrious known, the income and consumption position of a manager will check over his or her willingness to undertake risky projects.Optimal delegation requires that this risk attitude is not too different from shareholders own. The second feature may have to be modified if the managers risk tolerance is inherently different from that of the shareholders. The typical motivation for stock options (as opposed to pure rectitude positions) is precisely that the (recurrent) lack of income diversification of a manager may own her excessively prudent (in pursuit of a quiet life). This is the cerebration behind setting executive compensation according to a extremely convex contract, i. e. ne where the upside is really good, but the downside is not so bad. This asymmetry is necessary induce risk averse managers to make the flop investment decisions from the perspective of well-diversified stockholders . Are options-dominated contracts warranted? Shareholders receive both wage and dividend income, with the wage or salary gene being, on average, the larger of the two. This is an implication of case Income Accounting. In the typical modern economy, about 2/3rds of GDP is smooth of wages, with capitals income account for only 1/3.Points 1 and 2 above therefore imply that an optimal contract will have both a salary (with properties close to those of the wage bill) and an incentive theatrical role (with properties naturally linked to the income accruing to capital owners) with the former being about doubly as large as the latter. The incentive region may take the form of a non-tradable equity position (giving the right to regular dividend payments) or it may be more than closely tied to the firms stock price itself. Furthermore, both of these components enter linearly into the managers compensation function.In todays business world, the salary component appears to be too small s exual relation to the incentive component. Hall and Murphy (2002) report that the grant date value of stock options represented 47% of average CEO pay in 1999. Equilar, Inc. , an executive compensation consultatory firm, reports that stock options awards represented 81% of CEO compensation for the largest 150 te Valley firms in 2006. What happens to incentives if the salary component is too small relative to the incentive component?Such an imbalance between the components of a managers compensation will lead to excessive smoothing of the firms output from the shareholders perspective. They typically prefer a highly pro-cyclical investment polity whereas, without further inducement, the manager will be much more unwilling to exploit the good opportunities and instead select a mildly pro-cyclical or, even, maybe an anti-cyclical investment strategy. This problem is well recognized, and it is the main justification for using highly convex managerial compensation contracts (i. e. op tions).Convex contracts overcome this possibility by reducing the personal (expected) cost to the manager of increasing the firms investment when times are good. If the managers preferences are well represented by a logarithmic utility function of consumption, however, then this latter argument does not apply the managers actions will be insensitive to contract convex shape. That is, even a compensation contract that is heavily laden with options will not induce managers to alter their way one whit. A straightforward application of this logic produces an even more striking result.If the manager happens to be more risk averse than would be dictated by log utility an entirely plausible kind the only way to induce optimal managerial behavior is by using a highly unconventional remuneration package in which the managers compensation is inversely related to the firms operating results. This would mean a contract that pays high compensation when sugar are low and vice versa. In this situation an options laden compensation package will induce the manager to behave in a manner directly opposite to what the shareholders would like.More generally, the degree of contract convexity must be related to the relative risk aversion of the manager as compared to the shareholders and if these quantities are not precisely estimated large welfare losses will ensue. From a theoretical macroeconomic perspective, the flock under which a highly convex compensation contract, for example, one that has a large component of options, will properly guide the manager in making the correct hiring and investment decisions are very narrowly defined. It would be surprising if these circumstances were fulfilled in the typical contract case.