We empirically analyze the dynamics of executives' pay-to-performance sensitivities. Option pay-to-performance sensitivities become weaker as options fall underwater, often leading to pressures to reprice options or restore pay-to-performance sensitivity in other ways. Building a detailed data set on executives' portfolios of stock and options, we find that the responsiveness of pay-to-performance sensitivities (created by all executive holdings of stock and options) to changes in stock price is large. The elasticity of pay-to-performance sensitivities with respect to stock price decreases is about 0.7 and is larger for high-option executives and for executives with high percentages of options already underwater. The dominant mechanism through which companies offset declines in option pay-to-performance sensitivities is larger option grants following stock price declines; on average, these larger grants restore approximately 40% of the stock-price-induced pay-to-performance sensitivity declines. Option repricings are inconsequential in this regard, despite the attention they have attracted. In looking at positive returns, we find the reverse: higher returns both directly increase pay-to-performance sensitivities and lead to larger option grants, which raise pay-to-performance sensitivities further. Thus, option grants to executives tend to be largest following large stock price increases or large stock price decreases. Copyright University of Chicago on behalf of the Institute of Professional Accounting, 2004.

No abstract

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and participants at the NBER Summer Institute for helpful conversations. Chandra Subramaniam kindly provided us with detailed repricing data, for which we are grateful. We thank Sandra Nudelman, Jia Jia Ye, Tong Chen and especially David DeRemer for helpful research assistance. The views expressed herein are those of the authors and not necessarily those of the National Bureau of Economic Research.

We analyze and explore option fragility, the notion that option incentives are fragile due to their non-linear payoff structure. Option incentives become weaker as options fall underwater, leading to pressures to reprice options or restore incentives through additional grants of equity-based pay. We build a detailed data set on executives' portfolios of stock and options and find that executive options are frequently underwater, even when average stock returns have been high. For example, at the height of the bull market in 1999, approximately one-third of all executive options were underwater. We find that, in contrast to the incentives provided by stock, the incentives provided by options are quite sensitive to stock price changes, especially on the downside. Overall, we find that the incentives created by all executive holdings have an elasticity with respect to stock price decreases of about 0.7, and this elasticity is larger for high-option executives and for executives with high percentages of options already underwater. The dominant mechanism through which companies manage option fragility is larger option grants following stock price declines; on average, these larger grants restore approximately 40% of the stock-price-induced incentive declines. Option repricings are far less prevalent, despite the attention they have garnered. Interestingly, we find that for positive stock returns, higher returns lead to larger option grants, which raise incentives further. Thus, option grants are largest when companies do very poorly or very well. Executive exercising behavior also affects option fragility. Since executives are much less likely to exercise options following stock price decreases, the natural declines in incentives due to exercises are attenuated on the downside, leading executives to "manage their own incentives" in a way that augments company management of option fragility. AbstractWe analyze and explore option fragility, the notion that option incentives are fragile due to their non-linear payoff structure. Option incentives become weaker as options fall underwater, leading to pressures to reprice options or restore incentives through additional grants of equitybased pay. We build a detailed data set on executives' portfolios of stock and options and find that executive options are frequently underwater, even when average stock returns have been high. For example, at the height of the bull market in 1999, approximately one-third of all executive options were underwater. We find that, in contrast to the incentives provided by stock, the incentives provided by options are quite sensitive to stock price changes, especially on the downside. Overall, we find that the incentives created by all executive holdings have an elasticity with respect to stock price decreases of about 0.7, and this elasticity is larger for high-option executives and for executives with high percentages of options already underwater. The dominant mechanism through which companies manage option fragility is larger option grants foll...