Optimal Strike Prices of Stock Options for Effort Averse Executives

Abstract

This paper evaluates the common practice of setting the strike prices of executive option plans at-the-money. Hall and Murphy, 2000, claim this practice to be optimal since it maximizes the sensitivity of compensation to firm performance. However, they do not incorporate effort and the possibility that managers are effort averse into their model. We revisit this question while explicitly introducing these factors and allowing the reward package to include fixed wages and options or stock grants. We simulate the firm's decisions and the manager's effort choice under alternative compensation schemes and identify schemes that are optimal. Our simulations indicate that when abstracting from tax considerations, it is optimal to establish the strike price in-the-money. However, when issuing in the money options creates tax related disadvantages, it may be optimal to issue at-the-money options. We show that the above result holds both in the case when the strike price is linked to an economy-wide benchmark and when it is not benchmarked. Our simulations also indicate that issuing options with benchmarked strike prices usually dominates issuing options with non-benchmarked strike prices.