Monday, October 15, 2007

stock options

Krugman has beat me to the punch on this, but Floyd Norris' article in the Friday Times is interesting. He summarizes a paper looking at the effect of stock options on CEO risk-taking. The paper finds that there is a tendency to take inefficient levels of risk associated with being paid with options. This is what would be predicted by simple theory, but I haven't seen it tested before. Here is an example I use with my classes:

Suppose a CEO has option with exercise prices equal to the current market price of the stock, $20. She has two directions she might take the company in. In one, earnings and therefore the stock price, will more or less certainly increase by 20% over the next year (the "therefore" depending on the heroic assumption that the stock market is efficient). With the other direction, earnings have equal chances of doubling or being cut in half. Unless the owners are insanely risk-loving, the second direction is one they would never take; it has both higher variance and lower (actually zero) expected return. The CEO, on the other hand, makes an expected return of $4 per share taking the first direction, compared to 1/2($20) = $10 taking the second. The point is that, for the CEO, the 2nd direction constitutes a one-sided gamble. If the price doubles he exrecises the option and makes $20 per share. If the pice tanks, the option is worthless - the CEO neither gains not loses: heads, she wins; tails, the stockholders lose. Norris notes that in-the-money options would take away these perverse incentives - then the CEO would lose something if the stock price fell. (Hmm: is this last point destined to emerge as part of an apologia for back-dating options!)


Anonymous said...

I too saw that article, and then I wrote it up in a paper about CEO pay for a certain professor of mine ;-) suggesting that we might want to think twice about compensating for risk. I think about THE AFFLUENT SOCIETY and I wonder if we want to be rewarding risk instead of some sort of social program. I am not sure we need more money or stuff floating around. Although, I am sure more food, shelter and clothing would be nice for a lot of people.

Shag from Brookline said...

Do any executives who exercise stock options actually pay out cold cash for the stock AND hold on to the stock because of his faith in the corporation and also to satisfy the long-term capital gain holding period so that the tax on a sale of the stock can be at low rates? Or are most executives risk averse and excercise options with arrangements to promptly sell and cash in at ordinary income rates without actually laying out any of their own cash?

Anonymous said...

I am not completely following your example as to whether it shows that stock options encourage risk-taking or not.

With stock options, compared to other types of compensation, less risk is needed to get greater gains because of the upside leverage with stock options. For example, a 5% increase in the company's stock price produces a much greater than 5% gain in the value of stock options compared to a grant of restricted stock.

With all these studies I raise similar type issues:

1) Do you really think stock options (or any type of compensation) alone encourage risk taking and are the only motivator for senior executives?

2) Have you really controlled for all other variables? Could there be other factors that are involved in companies that make large stock option grants to CEOs. What else seems to correlate with the results? Could the causation link be something else?

3) Since we strongly believe in pay-for-performance for executives, is there something that unique about stock options that lead to these results, or would the same results appear with another type of leveraged compensation?

Bruce Brumberg, Editor

Unknown said...

I'm not sure I follow your logic here. In the first case, earnings go from $100 (say) to $120.

In the second case, there's a 50% chance that earnings will be $200, and there's a 50% chance that earnings will be $50. Which means that exepcted earnings are $125, which is higher than $120, and certainly constitutes a non-zero expected return.

Now I'm not say that the owners would choose Plan B. And I do understand that you can recast your Plan B so that there's a 50% chance of earnings being wiped out entirely, thereby making your logic work. But under your "heroic" assumption, the company would be worth zero after one year of zero earnings, which doesn't make a lot of sense either...

kevin quinn said...

Felix: Whoops. How about making Plan B have equal probability of taking earnings per share to 40 or 0. Sorry. Thanks,


kevin quinn said...

Bruce: the CEO with stock options is rewarded for high earnings, but not penalized for low - and so is encouraged to take inefficient risks. There would be no such incentive if pay varied in both directions with the stock price. There are many different sorts of payment-for-performance, some sensible, some not.

Suppose your workers produced $100 worth of widgets daily and were paid a flat wage. You offer a $30 bonus if they exceed a target of $150/day. There is a pill they can take that will give them a 50% chance of producing $160 and a 50% chance of producing only $20. It costs a quarter. With this particular payment-for performance scheme, they will all take the pill (the expected gain is $15 - $.25) reducing expected output to $90/day! This is an analogue, I think, to the stock option case.

Anonymous said...

Where did we get the absurd idea that the CEO, or even the entire executive corp of a given corporation, is responsible for the success of that corporation? What are the rest of the employees responsible for? The failure of the company? The success of any complex organization is a result of all the parts of that organization working in unison towards a given end. The factors involved in the ultimate success of the organization are far more complex than simply saying the CEO did it.
Does any one expect that the executive group in any company is going to pay back their past compensation if the corporation tanks? Not likely. They'll probably get paid yet a few more million to "guide" the company through bankruptcy and reorganization. Hell of a system. By the way, who is it that chooses the executive compensation "consultant" that recommends those pay for any performance contracts?
Let me guess. The guy in charge.