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.

(153 K)

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

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