NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Optimal Exercise Prices for Executive Stock Options

Brian J. Hall, Kevin J. Murphy

NBER Working Paper No. 7548
Issued in February 2000
NBER Program(s):   CF   LS   PE

Although exercise prices for executive stock options can be set either below or above the grant-date market price, in practice virtually all options are granted at the money. We offer an economic rationale for this apparent puzzle, by showing that pay-to-performance incentives for risk-averse undiversified executives are typically maximized by setting exercise prices at (or near) the grant-date market price. We provide an operationally useful alternative to Black-Scholes (1973) for the purpose of both valuing executive stock options and measuring the incentives created by options. Our framework has implications not only for exercise-price policies, but also for indexed options, option repricings, exchanges of cash for stock-based compensation, and the design of bonus plans.

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Document Object Identifier (DOI): 10.3386/w7548

Published: American Economic Review, Vol. 90, no. 2 (May 2000): 209-214

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