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

Options have become a major component of corporate compensation. Their cost to firms depends on the exercise policies of executives who face hedging constraints. This paper ana-lyzes the optimal policy and option cost for an executive with general concave utility. We show analytically how the policy and cost vary with risk aversion, wealth, and dividend, and when there exists a single stock price boundary. We also provide an example with a split continua-tion region, and numerical results on volatility and beta effects. Option value decreases with risk aversion, increases with wealth and hedging opportunities, but can actually decline with volatility. Options have become a major component of corporate compensation, with Frydman and Saks (2007) finding that options represent over 40 % of total compensation for the top three executives in a sample of large firms. While option compensation is widely believed to create valuable performance benefits, firms, investors, and regulators are also becoming concerned about its cost, since a better understanding of option cost can help firms decide how to use options most efficiently. Recent accounting regulation, requirin