The Downside Risk

Options for top managers

Stock options worth more for women, senior managers, study finds January 7, by Sam Zuckerman A novel new way of determining the value of employee stock options has yielded some surprising insights: Options granted to woman and senior managers are worth more because they hold them longer.

And options that vest annually rather than monthly are worth more for the same reason.

What You Need to Know About Stock Options

Jennifer N. Their analysis also draws options for top managers behavioral economicswhich considers the effects of psychology on financial decisions. And awards to the most senior employees cost 2 to 7 percent more than grants to their lower-ranking colleagues—again, because the execs hold onto them. In addition, options cost companies significantly more when they are set up to vest less frequently—that is, reach the threshold date when they become eligible to be exercised.

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A shift from an annual to a monthly vesting date reduces option value by as much as 16 percent because people exercise the options earlier and more often. According to a recent survey by Meridian Compensation Partners42 percent of companies responding reported they awarded stock options to senior executives.

Executive compensation

And options represent more than 20 percent of CEO pay, according to options for top managers estimate. Options allow holders to buy a specific stock at a set price until a predetermined expiration date. The basic challenge in determining the cost of employee stock options is that their value depends on how long they are kept. In general, the longer they are held, the greater the cost to the company that issued them.

Consequently, the key to valuing them is to predict accurately when they will be exercised. A vast literature examines how to determine the value of stock options traded on exchanges. But employee stock options are a special breed with their own special characteristics.

Looking at Management Stock Options

For that reason, the valuation methods originally developed for exchange-traded options are imprecise when applied to the options companies award their employees.

Standard option theory takes into account several factors to forecast when options will be cashed in.

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But it was largely developed through studies of exchange-traded options, making it out of whack for employee stock options for several reasons. Second, they can only be used during a multi-year window that starts when they vest and ends when they expire. New model factors in behavior and risk To arrive at a more accurate way of estimating when employees would exercise stock options, Stanton, Carpenter, and Wallace, the Lisle and Roslyn Payne Chair in Real Estate Capital Markets, analyzed a unique set of data that included complete employee stock option histories awarded to someemployees from to at 88 publicly traded corporations.

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The dataset gave them an unprecedented fine-grained look at option-exercise behavior. The authors then constructed a mathematical model of exercise rates that took relevant factors from standard theory and added factors related to the riskiness of the options, based on portfolio theory, along with some additional behavioral factors and information on the terms governing options grants, along with characteristics of issuing companies and option holders.

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Their findings included some surprises. For example, vesting frequency had an especially powerful effect on option cost. The obvious reason is that employees are able to exercise options earlier when they vest more frequently. But something else may be at work—employees receive an email when options vest, which may prompt them to pull the trigger.

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Similarly, men may exercise options earlier and more often than women because they are more confident making financial decisions. That finding is in line with influential work by Berkeley Haas Prof.

Re-examining Stock Options as a Way to Compensate Executives

Terrance Odeanwho found that male investors trade more frequently than women—behavior that reduces their net returns. But why do high-ranking employees hold their options longer than lower-ranking colleagues? Almost ten years in the making, the research was funded by the Society of Actuaries in response to regulatory calls for improved employee stock option evaluation methods.