The Valuation of Executive Stock Options when Executives Can Influence the Payoffs

It is widely believed that executives value stock options at less than market or Black-ScholesMerton values. This belief is contingent, however, on a subtle assumption that executives are, like shareholders, price takers with no ability to influence the underlying stock. But executives clearly have the ability to influence the stock, as that is the principal reason why they are granted the options. As such, executives are likely to be more willing to hold options than would ordinary investors, an important fact not captured in conventional models. We develop a model in which executives exert costly effort to alter the stock return distribution. We find that when executives act optimally, their options are worth much more than generally believed and potentially more than the market values of the options. We also find that accounting for effort can alter early exercise behavior, leading higher-quality executives to exercise later. The Valuation of Executive Stock Options when Executives Can Influence the Payoffs