Optimal exercise of executive stock options and implications for firm cost. Working Paper

As options have become a major component of corporate compensation, the demand for better valuation has intensi¯ed. The di±culty is that option cost depends on the exercise policies of executives who face hedging constraints. This paper analyzes the optimal policy for a general utility-maximizing executive holding a nontransferable option. We show analytically how the policy varies with risk aversion, wealth, and dividend rate, and when the policy is characterized by a single stock price boundary. We also provide an example with a split continuation region. In CRRA examples, option value decreases with risk aversion, increases with wealth, increases with outside hedging opportunities, but can actually decline with volatility. Options have become a major component of corporate compensation, with Frydman and Saks (2007) ¯nding that options represent over 40 % of total compensation for the top three executives in a sample of large ¯rms. While option compensation is widely believed to create valuable performance bene¯ts, ¯rms, investors, and regulators are also becoming concerned about its cost, since a better understanding of option cost can help ¯rms decide how to use options most e±ciently. Recent accounting regulation, requirin