Bruce A. Rosser

Executive Stock Options: Evidence that Premium and Discount Awards Do Matter

We document a structure of pre-effort conditions associated with ESOPs. Since we can observe shareholder returns at award we infer incentive effects in a setting where premium and discounted executive stock options are regularly awarded. Discounted (premium) awards are associated with the highest (lowest) exercise rates, implying a successful incentive (disincentive) effect. Exercise restrictions (comprising hurdles and vesting restrictions) necessarily lower exercise rates, but may be preferred in combination with a discounted or premium award. Typically, a discount choice is associated with hurdles but not vesting restrictions. Empirically, shareholders benefit most from regular awards which are discounted and do not have hurdle price restrictions. Shareholders also benefit from hurdle provisions in irregular awards which may expose shareholders to CEO opportunism.

A Test of the Incremental Power of CEO Productivity in Optimum Incentive Modelling

Employing a unique dataset with varying grant sizes and exercise prices, we test the competing optimal option incentive models of Hall and Murphy (2000, 2002) (HM) and Baker and Hall (2004) (BH) which differ with respect to the impact of CEO productivity on incentive determination and also the treatment of risk aversion and firm risk. Direct testing of the BH model proves more satisfactory than direct testing of the HM model, but given this outcome, it is surprising that the HM model explains a higher proportion of grant abnormal returns than does the BH model. We attribute this outcome to PPS and not the exercise price. Since exercise prices have been shown unrelated to agency problems, we conclude that caution needs to be exercised when prescribing exercise prices to create the optimal incentive, especially for highly risk-averse CEOs and those who are also poorly diversified.

DISCOUNT AND PREMIUM AWARDS IN THE CONTEXT OF PRE-EXISTING ESOP CONDITIONS

This study examines interactions between pre-award ESOP restrictive conditions and award discounts/premiums that characterized executive stock option awards in Australia from the mid1980s to 2000. Shareholder wealth effects at award suggest that (i) shareholders generally do not gain from offering discounts because associated value increments do not exceed the cost of the discount, (ii) premium awards coupled with exercise restrictions appear to be used to ameliorate the risk of CEO opportunism associated with irregular awards, and (iii) shareholders suffer a wealth decrement when premium awards are used to ameliorate the disinvestment incentive of inferior CEO dilution protection. The second of these findings implies risk of CEO opportunism. A major implication is that award discounts/premiums are used to modify the conditions of pre-existing ESOPs that presumably are dated and no longer optimal for addressing current incentive problems. Analyses of the optimality of award discounts/premiums should take this into account.