Leverage, volatility and executive stock options

Abstract

This paper studies how an optimal wage contract can be implemented using stock options, and derives the properties of the optimal contract with stock options. Specifically, we show how the exercise price and the size of the option grant should change in respose to changes in exogenous parameter. First, for a fixed exercise price of executive stock options, the size of the option grant decreases in the riskiness of a desired investment policy, decreases in the volatility of return from the risky project, and increases in leverage. Second, for a fixed size of the option grant, the optimal exercise price of managerial stock options increases in the riskiness of a desired investment policy, increases in the volatility of return from the risky project, and decreases in leverage. Several empirical predictions are drawn from these conclusions regarding the pay-performance sensitivity of management compensation.

Determinants Of Stock Option Use By Chinese Companies

“…This contradicts the prediction that the disciplinary role of debt may reduce agency costs, and higher leverage would be associated with less need for equity incentives. However, our result is consistent with Alves (2011)'s finding and this can be explained with Choe (2003)'s theory that the number of stock options is increased to alleviate management underinvestment problem. Moreover, if high financial leverage indicates a shortage of cash, more stock options are used in place of cash compensation.…”

“…Empirically, Bryan et al (2000), Chourou et al (2008), Ittner et al (2003), Kato et al (2005), Ryan and Wiggins (2001) and Uchida (2006) report a negative association between stock options and leverage. In contrast, Choe (2003) develops a model in which stock option awards increase in leverage. He argues that higher leverage reduces the value of stock options by raising the effective exercise price of options, making risky projects less desirable to mangers.…”

Information asymmetry, contract design and process of negotiation: The stock options awarding case

“…The managerial power hypothesis offers a new approach to understand the process leading to jointly agreed stock option contract, which is not the optimal contract imposed by the standard incentive theory that gives the bargaining power to shareholders. Choe's (2003) model determines endogenously the stock option contract features and introduces parametrization of the exercise price and the size of option grant. In conclusion, Choe suggests to develop further analysis to question the optimality of the traditionnal at-the-money setting practise and to introduce managers' risk aversion.…”

“…However, we favor the context of the "managerial power" approach of Bebchuk and Fried (2003) who underline that the agents have enough power to set their own pay, or that of Ryan and Wiggins (2004) who emphasize the importance of a bargaining process in determining the compensation schemes. Like Choe (2003), we stylize the design of a stock option plan in a firm as a set of two choices about the stock exercise price and the percentage of capital awarded to managers. The analysis developed hereafter will focus on the trade-off between these two parameters of the contract from each party's point of view.…”

Should Executive Stock Options Be Abandoned?

“…An option-based contract does not necessarily lead to excessive risk taking if the terms of the contract such as the size of the grant, maturity and exercise price, are chosen optimally (Carpenter, 2000;Choe, 2001Choe, , 2003.…”