Managing Option Fragility

Abstract

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...

Reexamining the managerial ownership effect on firm value

“…To determine if this method is biasing our results, we reexamine the option portfolio results using only current year options. We use the Murphy (1999) and Coles et al (2003) one-year approximation method and the Hall and Knox (2002) algorithm to estimate the executive's option portfolio. The correlations of the various option estimation methods are above 99%.…”

Large Sample Evidence on the Relation Between Stock Option Compensation and Risk Taking

“…If ESOs are not effective at mitigating CEO risk aversion, then the distinctive feature of ESOs relative to stock i.e., the risk-taking incentives, is called into question. While ESOs offer risk-incentives due to convexity in payoffs, as pointed out by Lambert, Larcker and Verrecchia (1991), and Hall and Knox (2002), these incentives are fragile especially when the stock price falls relative to the option's exercise price. Thus, our paper provides evidence to inform the current debate about the relative efficiency of restricted stock versus options in motivating manager behavior.…”

A quantum metric of organizational performance: Terrorism and counterterrorism

“…In essence, if a skilled group can build a highly-prized product such as a house, it matters not whether its beliefs or K about house-building correspond or contradict its practices (Gershenfeld, 2000), but we assume for now that cooperation among the members of a well-knit team produces the least amount of I . In the solution of wdp's, individuals function in roles bonded into a stable network or structure oriented by a common K set within a shared emotional potential E field; to illustrate, the first goal of the Nazi's was coordination between ideology and action in Germany (Benz, 2006); and as a counter example, during the late 1990's stock market bubble, stock options were designed but failed to align the well-articulated interests of management and stockholders (Hall and Knox, 2002).…”