Estimating the Cost of Executive Stock Options: Evidence from Switzerland

It is often argued that Black-Scholes (1973) values overstate the subjectivevalue of stock options granted to risk-averse and under-diversified executives.We construct a “representative” Swiss executive and extend the certainty-equivalence approach presented by Hall and Murphy (2002) to assessthe value-cost wedge of executive stock options. Even with low coefficientsof relative risk aversion, the discount can be above 50% compared to theBlack-Scholes values. Regression analysis reveals that the equilibrium levelof executive compensation is explained by economic determinant variablessuch as firm size and growth opportunities, whereas the managers’ pay-forperformancesensitivity remains largely unexplained. Firms with largerboards of directors pay higher wages, indicating potentially unresolvedagency conflicts. We reject the hypothesis that cross-sectional differences inthe amount of executive pay vanish when risk-adjusted values are used asthe dependent variable.