Stock Options

Stock options increasingly dominate CEO pay packages. This column outlines when economic theory suggests that options-heavy fee is in shareholders interests. The answer is that boards of directors are likely giving too many executive stock options. As boards of directors call for sought to align the interests of four-in-hands and stockholders, executive stock options take for become an ever- heavy(p)r division of the typical CEOs total pay (Murphy 1999). Occasionally 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 context? From a conceptual perspective, how effective is the granting of stock options in promoting the correct private instructorial decisions? How confident can we be that when a large fraction of a handlers compensation assumes this form he or she will be led to accept the same labor hiring and c apital enthronization decisions that the shareholders would themselves want to undertake if they were similarly informed?Managerial fillips and the design of compensation contracts are the systemic implications of executive remuneration are taken into account, that is, in a general equilibrium context one finds that for a contract to reach managers to take the correct business decisions in the to a higher place sense, it must naturally have the following three features. A significant portion of a managers remuneration must be based, in one way or another depending on the context, on her own firms performance.This concurs with the general message 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 consequence of this first requirement, enjoying an income stream with clip series properties that are too different from the time series properties of the income stream enjoyed by share holders. This later restriction arises because, as is well known, the income and consumption position of a manager will determine 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 rightfulness positions) is precisely that the (recurrent) lack of income diversification of a manager may put one over her excessively prudent (in pursuit of a quiet life). This is the idea behind setting executive compensation consort to a highly convex contract, i. e. ne where the upside is really unspoilt, but the downside is not so bad. This asymmetry is necessary induce risk averse managers to make the right investment decisions from the perspective of well-diversified stockholders. Are options-dominated contracts w arranted? Shareholders receive both wage and dividend income, with the wage or salary component being, on average, the larger of the two. This is an implication of subject Income Accounting. In the typical modern economy, about 2/3rds of GDP is composed 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 component (with properties naturally conjugate to the income accruing to capital owners) with the former being about twice as large as the latter. The incentive component may take the form of a non-tradable equity position (giving the right to regular dividend payments) or it may be more closely tied to the firms stock price itself. Furthermore, both of these components grave linearly into the managers compensation function.In todays business world, the salary component appears to be too small sexual relation to the incentive com ponent. 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 advisory firm, reports that stock options awards represented 81% of CEO compensation for the largest 150 Silicon Valley firms in 2006. What happens to incentives if the salary component is too small sex act to the incentive component?Such an imbalance between the components of a managers compensation will lead to excessive smoothing of the firms rig from the shareholders perspective. They typically prefer a highly pro-cyclical investment policy whereas, without further inducement, the manager will be much more reluctant to exploit the good opportunities and instead select a mildly pro-cyclical or, even, possibly an anti-cyclical investment strategy. This problem is well recognized, and it is the main justification for victimisation highly convex managerial compensation contracts (i. e. options).Convex contracts over come 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 convexity. That is, even a compensation contract that is heavily laden with options will not induce managers to interpolate their behavior 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 configuration 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 believe a contract that pays high compensation when profits are low and vice versa. In this situati on 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 hazard 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.