A Comparison of Stock Options and Stocks from an Optimal Con-

While stock options have been the subject of many studies, (restricted) stock as a form of compensation has long escaped similar scrutiny (Bryan et al., 2000). Most papers focus on the question of whether stocks or options can better align managers’ and own-ers’ interests and lead to better performance. Given that companies have different characteristics, such as size, available capital, business foci, and along with it, differ-ent requiremdiffer-ents in managerial actions (Kole, 1997), and that managers differ in their wealth and risk aversion (Nohel and Todd, 2004), it is not likely that there will be only one optimal form of compensation. It may also explain why research results are often contradictory.

A possible starting point for any analysis could be the costs the company incurs when giv-ing out stocks or options. As stated before, this is the opportunity cost of the instrument and since American call options can never be more valuable than the underlying stock (Hull, 2012), they are generally cheaper than stocks. Hall (1998) shows that replacing stock holdings by options with the same value almost doubles the pay for performance sensitivity for the median CEO.

One must, however, also recognize that executives often value options below the cost to the company because of the restrictions on trading and hedging. Companies will always incur the full fair value as an opportunity cost. When granting options, they also incur a “deadweight cost”, that is the difference between the cost and the value assigned to it by the manager.³⁷ Meulbroek (2001b) reports that undiversified managers value options at about 50% of their costs to the company.³⁸ So to provide payment at or above

35For annual bonus plans, Murphy and Jensen (2011) show that this can lead to too little risk-taking by the managers.

36See Table 4.3.

37As pointed out before, the same holds true for restricted stocks.

38A fully diversified manager of a large company values his or her options at up to 88% of market value. Hodge, Rajgopal, and Shevlin (2009) do not find such a deadweight cost for entry- or mid-level employees. In fact, they see stock options as more valuable than restricted stock grants with the same fair value.

the manager’s next best alternative, companies will have to grant more options than stocks. While Meulbroek’s analysis ignores incentive effects of options, she concludes that options are likely not a cost efficient means of compensation.

Hall and Murphy (2002) use a certainty-equivalent approach and find that managers who have their wealth tied up in the company value options at only half of the fair value.

Under the assumption that overall pay is fixed (i.e., higher equity-based compensation leads to reductions in cash and/or bonuses of the same value), restricted stocks will maximize incentive efforts.³⁹ Options will only be chosen if grants are given on top of current compensation packages, in which case stocks are more expensive.⁴⁰ Finally, they show that in this situation at-the-money options will yield high incentive efforts.

A similar result is obtained by Jenter (2002) who concludes from his model that be-cause of the substantially reduced option value the manager sees and the fact that PPS overstates incentive effects of options due to a negative correlation with marginal util-ity, they are an inefficient means of compensation when compared with restricted stock.

Feltham and Wu (2001) show in their model framework that when managers only influ-ence the mean of the output, stocks dominate options. In the case that managers can also influence the operational risk, this is no longer the case and options can be optimal.

These studies, whose results naturally depend to a large degree on the model assumptions have been criticized by other authors. Lambert and Larcker (2003), for example, note that neither Meulbroek (2001b), nor Hall and Murphy (2002), nor Jenter (2002) specify a full equilibrium model, as they either exclude the full costs of the options or the value to the employee and the provided incentive effects. They go on to set up a full model that in contrast to Feltham and Wu (2001) also allows for stocks and options to be given simultaneously and more general forms of utility functions. That way they can show that stock options generally fare better than stocks. And not only that, they also show that premium options should be part of the optimal payment contract.

A similar conclusion is presented by Arnold and Gillenkirch (2007) who show that the assumptions made by Hall and Murphy (2002), Feltham and Wu (2001), and Jenter (2002) drive their results, as they all imply a concave compensation contract, which

39 Arnold and Gillenkirch (2007) point out that the maximum incentive level is not necessarily the optimal one.

40 See Lambert, Larcker, and Verrecchia (1991) for a discussion on how the portfolio effect impacts value and incentives of different executive compensation components.

stocks approximate better than options. When limited liability on the part of the man-ager is introduced in the standard agency model, stock options dominate stocks in the optimal compensation contract (Arnold and Gillenkirch, 2007).

Dittmann and Maug (2007) also employ a standard agency model and then calibrate it with actual compensation data from U.S. listed companies. The predictions made by the model that CEOs should have lower base salaries, more stock and close to no options does not comport with reality. They are not able to explain real-world option holdings and raise the question whether they can be efficient and effective in an optimal contracting view. Dittmann, Maug, and Spalt (2010), however, include loss aversion on the part of the manager and in such a setting their agency model can explain the high base salaries and the large option holdings very well. This confirms earlier results by several other authors. Bryan et al. (2000) analyze compensation contracts for a large U.S. sample and find that restricted stocks do not provide sufficient incentives to managers to engage in risky positive net present value projects. Likewise, Dodonova and Khoroshilov (2006) argue that loss aversion is the critical characteristic that makes convex payment structures as provided by options necessary. Dittmann and Yu (2011) make a similar point by demonstrating that options serve to induce risk-taking behavior and not merely as effort incentives. For that purpose, options granted at the money are optimal.⁴¹

A different approach to the comparison is undertaken by Irving, Landsman, and Lindsey (2011). They, like many others, note that restricted stocks have recently been becoming more relevant and they evaluate market reactions to the two instruments. Results show that markets seem to value stock option grants as intangible assets whereas they see restricted stock as a liability.

It should be noted that when giving options to managers who already have large stock holdings, they can undo some of the effects of options by selling off their previously owned shares. Therefore, the incentive effect will be higher for managers with low company ownership, unless there are selling restrictions on company shares (Ofek and Yermack, 2000). One negative aspect that both shares and options have in common is that high dependence of compensation on stock price has been found to be linked to higher earnings management (Bergstresser and Philippon, 2006).

41This holds when taxes are included in the deliberations. Otherwise it would be optimal to use in-the-money options.

All in all, research seems to point to the fact that options and especially well-designed options can have strong incentive effects that dominate those of restricted linear stock.

It will be interesting to see if this verdict will change now that performance-vested stock presents an accepted non-linear alternative.

2.3 The Pay Setting Process as an Extension of the