Estimating the Cost of Executive Stock Options: evidence from Switzerland

• Author: Markus M. Schmid,Pascal Pensa,Wolfgang Drobetz
• Date: 01 September 2007
• Published date: 01 September 2007
• DOI: http://doi.org/10.1111/j.1467-8683.2007.00612.x

Estimating the Cost of Executive

Stock Options: evidence from

Switzerland

Wolfgang Drobetz*, Pascal Pensa and

Markus M. Schmid

It is often argued that Black-Scholes (1973) values overstate the subjective value of stock

options granted to risk-averse and under-diversif‌ied executives. We construct a “representa-

tive” Swiss executive and extend the certainty-equivalence approach presented by Hall and

Murphy (2002) to assess the value-cost wedge of executive stock options. Even with low

coeff‌icients of relative risk aversion, the discount can be above 50 per cent compared to the

Black-Scholes values. Regression analysis reveals that the equilibrium level of executive

compensation is explained by economic determinant variables such as f‌irm size and growth

opportunities, whereas the pay-for-performance sensitivity remains largely unexplained.

Firms with larger boards of directors pay higher wages, indicating potentially unresolved

agency conf‌licts. We reject the hypothesis that cross-sectional differences in the amount of

executive pay vanish when risk-adjusted values are used as the dependent variable.

Keywords: Managerial compensation, incentives, executive stock options, option valuation-

risk aversion

Introduction

Not only in the US, but also in Continental

Europe f‌inance practice has increasingly

used performance-based compensation plans

as a means to align the incentives of managers

with those of shareholders (e.g. Frey and

Osterloh, 2000; Murphy, 1999). In addition to

cash bonuses and share allotments, stock

options have emerged as a principal compo-

nent of executive compensation. The argu-

ments supporting the use of executive stock

options are manifold.1First, they motivate a

f‌irm’s executives and attract higher skilled and

relatively less risk-averse managers because

these executives will naturally self-select into

f‌irms that offer more upside participation.

Second, options provide retention incentives

through a combination of vesting provisions

and long option maturities. Third, managers

tend to think like owners only by becoming

owners. Equity-linked compensation allevi-

ates principal-agentproblems between manag-

ers and shareholders (Jensen and Meckling,

1976) and provides incentives for executives to

take shareholder value maximising actions.

Finally, stock options allow f‌irms to conserve

cash and are therefore often regarded as

“cheap” from an accounting perspective.

However, with the introduction of the IFRS 2

“Share-Based Payment” standard all stock

option grants to employees must be expensed

as of January 1, 2005.2

While the benef‌its of equity-based com-

pensation are well understood and widely

accepted, it is surprising that its costs have

received much less attention. After all, as

noted by Meulbroek (2001), “[. . .] if the only

result of equity-based compensation was in-

centive alignment, no natural stopping point

would exist: managers’ compensation would

be 100 per cent equity-based.”3However, this

*Address for correspondence:

Wolfgang Drobetz, Chair of

Corporate Finance and Ship

Finance, University of Ham-

burg, Von-Melle-Park 5, 20146

Hamburg, Germany. Phone:

+49-40-42838-5506; E-mail:

wolfgang.drobetz@wiso.

uni-hamburg.de.

798 CORPORATE GOVERNANCE

Volume 15 Number 5 September 2007

© 2007 TheAuthors

Journal compilation © 2007 BlackwellPublishing Ltd, 9600 Garsington Road,

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is clearly not what is observed in practice, and

there are several explanations. First, principal-

agent models (e.g. Holmstrom, 1979; Harris

and Raviv, 1979) emphasize the eff‌iciency of

high-powered incentive contracts, but they

also recognise that there is a trade-off between

incentives and risk sharing. Second, maybe

the current pay-to-performance sensitivity is

suff‌icient to motivate managers towards bet-

ter performance.4Third, stock options may

encourage managers to take excessive risk

because increases in the volatility of a com-

pany’s stock price increase the value of its

options. However, managers with lots of at-

the-money (or in-the-money) options could

become overly cautious, unwilling to jeopar-

dise a large anticipated payoff that will accrue

even if the stock price increases at just the

T-bill rate.5Finally, there is a potential disparity

between the cost of an option grant and the

value of that grant to the manager. This value-

cost wedge depends on a number of factors,

including the degree of diversif‌ication in the

executive’s portfolio, the length of the vesting

period of the option, and the risk aversion of

the executive. For example, Meulbroek (2001)

documents that managersin the average NYSE

f‌irm value their options at only 70 per cent of

the market value. Hall and Murphy (2002)

argue that the growth in risk-adjusted pay has

been modest in the US over the last decade,

suggesting that executive value has increased

far less than company cost.

For options to achieve their stated objec-

tives, the recipients must not be allowed to

trade the options or take actions such as short-

selling company stock or to otherwise hedge

company stock price risk.6While exposure to

f‌irm-specif‌ic risk is essential for generating

managerial incentives, it also imposes eco-

nomic costs by forcing the recipients to hold a

less-than-fully diversif‌ied investment portfo-

lio. In fact, executives are forced (by vesting

requirements, insider sales restrictions, or

board pressure) to hold more company equity

than is desirable from a portfolio diversif‌i-

cation viewpoint.7Managers’ human capital

investment in the f‌irm and pension fund hold-

ings that are strongly related to the company’s

stock further increase their idiosyncratic risk

exposure. Overall, there is an inevitable trade-

off between incentive alignment and portfolio

diversif‌ication, and managers will discount

the value of their company equity holdings

because of this suboptimal risk sharing.

In the f‌irst part of this paper,we focus on the

common argument that Black-Scholes (1973)

values are too high, i.e. when opportunity

costs are taken into account, stock options are

an expensive way to convey pay. Black-Scholes

values provide an estimate of the company’s

cost of granting an option, but they do not

ref‌lect the value of a non-tradable option

to risk averse and undiversif‌ied executives.

We use the Hall-Murphy (2002) certainty-

equivalence approach and estimate the dead-

weight costs for a sample of Swiss f‌irms using

stock options as part of their compensation

packages. Switzerland is an interesting case to

analyse. First, the institutionalisation of share-

holdings had a strong effect on the structural

changes of the equity market after pension

plans became mandatory in the mid-eighties

and emerged as the major domestic invest-

ment force. Drobetz et al. (2006) report that

institutional investors manage almost 50 per

cent of all assets deposited with Swiss banks.

On the one hand, institutional investors could

promote the eff‌icient use of executive stock

options, but on the other hand, they should

have incentives to exert control. In fact, their

own monitoring activities might substitute for

the use of stock option plans as part of the

f‌irm’s optimal control structure. Second, while

the market for corporate control developed

slowly during the 1990s (e.g. Loderer and

Zgraggen, 1999), there have been serious

attempts by Swiss f‌irms to adopt interna-

tionally recognised corporate governance

principles in recent years. The adoption of

executive stock option plans has been a

central part of this development in corporate

Switzerland (e.g. Beiner et al., 2006).

In the second part of this paper, we take a

closer look at the relationship between the

level of executive compensation (including

stock options) and the quality of the f‌irm’s

corporate governance. Most previous work on

executive stock options regards managers’

pay arrangements as a (partial) remedy to

the agency problem (e.g. Baker, Jensen, and

Murphy, 1988; Jensen and Murphy, 1990). The

rise in executive compensation can be attrib-

uted to the widespread adoption of compen-

sation packages with high-powered incentives

since the late 1980s. This view is referred to as

the “optimal contracting approach” or “arm’s

length approach”. Recently, however, Bebchuk

and Fried (2003) have argued that executive

compensation should not only be interpreted

as an instrument for addressing agency prob-

lems, but it should rather be viewed as part of

the agency problem itself. The “managerial

power approach” suggests that managers’ pay

arrangements are determined both by market

forces that provide eff‌icient incentives and

assure value-maximising outcomes and by

managerial rent-seeking under weak corpo-

rate governance structures, which leads to

departures from the optimal outcome and gen-

erally benef‌its managers.8To shed light on this

prediction, we explore whether f‌irms with

ESTIMATING THE COST OF EXECUTIVE STOCK OPTIONS 799

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Journal compilation © BlackwellPublishing Ltd. 2007