Stock Options

Stock options increasingly dominate chief operating officer pay piece of lands. This column outlines when economic sup perplex suggests that options-heavy fee is in sh arholders interests. The answer is that boards of directors be likely giving too many a(prenominal) administrator note options. As boards of directors present sought to align the interests of animal trainers and telephone lineholders, executive stock options have become an ever- freehandedr fraction of the emblematic chief operating officers total honorarium (Murphy 1999). Occasionally this practice has light-emitting diode to marrow earnings payments that are so bigger as to mock the very fellowship they are supposed to encourage.What does economic surmise have to say close to executive allowance in a energizing context? From a conceptual perspective, how hard-hitting is the granting of stock options in promoting the correct passenger vehicleial decisions? How confident can we be that when a larg e fraction of a theater directors fee assumes this form he or she go away be led to chthonian admit the same labor hiring and uppercase investing decisions that the shareholders would themselves want to under win if they were as well informed?Managerial drawments and the design of remuneration guarantees are the systemic implications of executive take are taken into accounting system, that is, in a general equilibrium context virtuoso finds that for a get hold of to bring in coach-and-fours to take the correct business decisions in the above sense, it must naturally have the avocation three features. A significant batch of a managers fee must be based, in atomic number 53 way or another depending on the context, on her own riotouss performance.This concurs with the general message of a wealthiness of microeconomics studies. But this is not sufficient. The general contract characteristics must also be such that the manager is not, as a way out of this first requirement, enjoying an income stream with period serial properties that are too different from the time series properties of the income stream enjoyed by shareholders. This subsequently restriction arises because, as is well known, the income and economic consumption position of a manager lead determine his or her departingness to undertake crazy projects.Optimal delegation requires that this take a chance military posture is not too different from shareholders own. The chip feature whitethorn have to be modified if the managers risk tolerance is inherently different from that of the shareholders. The exemplary motivation for stock options (as opposed to comminuted equity positions) is precisely that the (recurrent) lack of income variegation of a manager may attain her excessively prudent (in pursuit of a quiet life). This is the idea lowlife setting executive compensation gibe to a highly 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 regular(a)ing off coronation decisions from the perspective of well-diversified stockholders. Are options-dominated contracts warranted? Shareholders absorb both(prenominal) wage and dividend income, with the wage or salary region being, on average, the bigger of the two. This is an implication of National Income Accounting. In the natural modern economy, about 2/3rds of gross domestic product is composed of wages, with capitals income account for solitary(prenominal) 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 serving (with properties naturally cerebrate to the income accruing to capital owners) with the former being about twice as large as the latter. The incentive part may take the form of a non-tradable equity position (giving the right to regular dividend payments) or it may be more closely fastened to the firms stock damage itself. Furthermore, both of these components enter linearly into the managers compensation travel.In immediatelys business world, the salary component appears to be too small relation to the incentive component. Hall and Murphy (2002) extend 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 atomic number 14 Valley firms in 2006. What happens to incentives if the salary component is too small recounting to the incentive component?Such an imbalance in the midst of the components of a managers compensation will lead to excessive smoothing of the firms output from the shareholders perspective. They typically favor a highly pro-cyclical investment polity whereas, without further inducement, the manager will be much more reluctant to utilise 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 apply highly convex managerial compensation contracts (i. e. options).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 expediency 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 hard laden with options will not induce managers to alter 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 o ptimal 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 profits are low and vice versa. In this slur an options laden compensation package will induce the manager to behave in a manner directly contrary 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 circumstances 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 t ypical contract case.