Managerial Ability and the Valuation of Executive Stock Options

The executive compensation literature argues that executives generally value stock options at less than market value because of suboptimal ownership and risk aversion. Implicit in this finding is the assumption that executives are, like shareholders, price takers. That is, they have no ability to influence the outcomes of the firms investments. Clearly, executives do have the ability to influence these outcomes, because that is the purpose of granting them the options. In this paper, we develop a model in which managers can exert effort and alter the distribution of the returns from the firms investments. We find that when executives choose their optimal effort, the values of their options are much higher than generally thought and potentially higher than the market values of the options. In empirical evidence, we show that firms having better stock performance use stock options more efficiently. In addition, the pay-for-performance sensitivity is also stronger among these firms. Therefore, we conclude that the managers ability plays an important role in the abnormal performance.