Underwater Options and the Dynamics of Executive Pay‐to‐Performance Sensitivities

Abstract

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.

Lower Salaries and No Options? On the Optimal Structure of Executive Pay

“…3 Hence, we feel entitled to argue that our modeling approach implements a variant of the "conventional" model. 2 CRRA preferences and lognormal prices have been used by Lambert, Larcker, and Verrecchia (1991), Hall and Murphy (2000), (2002), Himmelberg and Hubbard (2000), Hall and Knox (2004), Jenter (2002) and Oyer and Schaefer (2003). Closely related are models that combine CRRA-preferences with geometric binomial trees or geometric Brownian motion models of stock price development that generate identical or similar distributions of stock prices.…”

“…We discuss their work below. An incomplete list of calibration exercises includes Lambert, Larcker, and Verrechia (1991), Hall and Murphy (2000), (2002), Hall and Knox (2004), and Jenter (2002). 1 1 See the literature cited in footnote 39 below and the discussion in the survey of Core, Guay, and Larcker (2002), section 3.2.…”

“…We conclude that the use of stock options to create risk-taking incentives might explain why we do not observe general nonlinear contracts, but this argument does not appear strong enough to explain why observed contracts are convex instead of linear. 31 …”

Extrinsic Rewards and Intrinsic Motives: Standard and Behavioral Approaches to Agency and Labor Markets

“…The result is reinforced, of course, if the agent is risk averse. 8 Hall and Knox (2004) estimate that at the height of the bull market in 1999, roughly a third of executive options were under water. Companies often respond to this non-linearity in stock option returns by increasing option grants following stock price declines.…”

The Original Management Incentive Schemes

“…Some of the criticisms of modern stock-option dominated schemes are as follows. First, stock options are worth nothing at all if the stock price doesn't rise above the exercise level, which may encourage excessive risk-taking (Holmström and Milgrom, 1987;Hall and Knox, 2005). Second, options where the actual stock price falls far below the exercise price (so that the option is "out-of-the-money") may provide little incentive.…”