Valuing Executive Options
Unlocking the Puzzle of Executive Stock Options
As investors, we've long been fascinated by the inner workings of executive compensation packages. One aspect that has puzzled researchers and practitioners alike is the valuation of executive stock options. A recent study published in the Journal of Financial Economics sheds light on this complex issue.
The research focuses on the exercise policies of executives, which differ significantly from those of ordinary options. This nontransferability makes executive options more difficult to value than their standard counterparts. To address this challenge, the study compares two models of a representative option holder's exercise policy.
A Simple yet Effective Model
One of the key findings is that a simple extension of the ordinary American option model can accurately predict exercise times and payoffs in a sample of 40 firms. This model introduces random, exogenous early exercise and forfeiture, which captures the unique characteristics of executive options. What's interesting is that this simpler model performs just as well as an elaborate utility-maximizing model that explicitly accounts for nontransferability.
The implications of this study are significant for investors, particularly those holding equity positions in firms with executive stock options. To understand why, let's consider a specific example: a firm like Goldman Sachs (GS) or Microsoft (MS), which have substantial executive option holdings.
Portfolio Implications
For portfolios invested in companies with large executive option holdings, the study suggests that a simple model can be an effective tool for estimating the opportunity cost of these options. This is particularly relevant for investors holding broad market indices like the AGG or QUAL. By accounting for the exercise policies of executives, investors can make more informed decisions about their portfolios.
However, there are also risks associated with executive stock options. One potential concern is that executives may exercise their options earlier than usual, leading to a decrease in shareholder value. Conversely, late exercise could result in missed opportunities for diversification and liquidity.
Actionable Insights
So what can investors do differently? First, they should consider the impact of executive stock options on their portfolio's overall performance. By understanding the exercise policies of executives, investors can make more informed decisions about their holdings. Second, investors should be aware of the potential risks associated with early or late exercise.