Ex Post Estimation Error in CEO Option Grants

The value of option grants to CEOs is defined in two different ways. Fair values are grant-date estimates of expected values from future option contract settlement. Payouts from exercise are realized values from option contract settlement. We refer to the cumulative difference between the fair values and payouts over an individual CEO's tenure as “ex post estimation error” (EPEE), because it represents information about option contract settlement that is not available at the grant dates. We find that the average EPEE amounts to 27% of the fair value of option grants among all ExecuComp CEOs from 1992 to 2009, contrary to beliefs that fair values are unbiased or they understate option-related payments that CEOs take home. We find that EPEE also varies with agency relations between CEOs and shareholders. EPEE is significantly higher in companies with outsider CEOs and in companies with high institutional ownership. These findings imply that agency relations between CEOs and shareholders influence option contract settlement and that pay comparisons that ignore option contract settlement may be misleading.(This paper was formerly titled "On the Quality of CEO Option Pay Estimates")