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Lecture Personnel economics in practice - Chapter 12: Options and executive pay

After today’s lecture, you will be able to address the following questions: When should a firm use stock options? How should options be structured? What is the best metric to measure executive performance? Who is responsible for stewardship of the corporation? Why are important checks and balances often underutilized/underemphasized? | Chapter 12: Options and Executive Pay 4/8/2013 Chapter 12: Options and Executive Pay Employee Stock Options Stock Options – A Brief Overview Should Firms Grant Employees Options? Source of Firm Financing Employee Self-Selection Reducing Turnover Options as Incentive Pay Performance Measure Pay-Performance Relationship Granting Options Over Time Other Incentive Effects of Options How Do Employees Value Options? Executive Pay What is the Most Important Question? Executive Pay for Performance Other Incentives and Controls Do Executive Incentives Matter? 4/8/2013 Chapter 12 – Options & Exec Pay After Today’s Lecture, you will be able to address the following questions: When should a firm use stock options? How should options be structured? What is the best metric to measure executive performance? Who is responsible for stewardship of the corporation? Why are important checks and balances often underutilized/underemphasized? 4/8/2013 3 Introduction Employee options differ from traditional | Chapter 12: Options and Executive Pay 4/8/2013 Chapter 12: Options and Executive Pay Employee Stock Options Stock Options – A Brief Overview Should Firms Grant Employees Options? Source of Firm Financing Employee Self-Selection Reducing Turnover Options as Incentive Pay Performance Measure Pay-Performance Relationship Granting Options Over Time Other Incentive Effects of Options How Do Employees Value Options? Executive Pay What is the Most Important Question? Executive Pay for Performance Other Incentives and Controls Do Executive Incentives Matter? 4/8/2013 Chapter 12 – Options & Exec Pay After Today’s Lecture, you will be able to address the following questions: When should a firm use stock options? How should options be structured? What is the best metric to measure executive performance? Who is responsible for stewardship of the corporation? Why are important checks and balances often underutilized/underemphasized? 4/8/2013 3 Introduction Employee options differ from traditional options can’t trade can’t hedge undiversified Stock = option w/ K = 0 restricted stock = employee option w/ K = 0 Stock Price (S) Payoff at Exercise (Intrinsic Value) Exercise Price (K) $ “Out of the money” “In the money” “Premium” “Discount” If S = issue date stock price Stock Options Terms Call Option: Right to purchase company stock at a predetermined price Put Option: Right to sell company stock at a predetermined price Strike Price: Fixed price set for exercising of option Question: What does in the money mean? 4/8/2013 5 Employee Stock Options – I Black-Scholes not necessarily useful for valuation of options used as compensation Vesting of options is very typical Employee holding period Holding periods legally required for Initial Public Offerings (IPO’s) Other conditions may apply E.g., expiration, contingencies, incentive and purchase plans (ISO’s, NSO’s, ESPP’s) 4/8/2013 6 Employee Stock Options – II Reasons offer for broad use of ESO’s Source of firm financing Employee .