Stock Options

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Stock options increasingly dominate CEO pay packages. This column outlines when economic theory suggests that options-heavy compensation is in shareholders’ interests. The answer is that boards of directors are likely giving too many executive stock options.

As boards of directors have sought to align the interests of managers and stockholders, executive stock options have become an ever-larger fraction of the typical CEO’s total compensation (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 managerial decisions? How confident can we be that when a large fraction of a manager’s compensation assumes this form he or she will be led to undertake the same labor hiring and capital investment decisions that the shareholders would themselves want to undertake if they were similarly informed? Managerial incentives 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 induce managers to take the correct business decisions in the above sense, it must naturally have the following three features. A significant portion of a manager’s remuneration must be based, in one way or another depending on the context, on her own firm’s 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 time series properties that are too different from the time series properties of the...
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