On the Benefits of Allowing CEOs to Time Their Stock Option Exercises

This paper shows that permitting executives to use inside information to time their option exercises can be part of an optimal pay arrangement. This is the case even though timing discretion enables executives to avoid losses by cashing out options on bad news, weakening the link between pay and performance. In the model, the CEO must be motivated to search for and implement a new project and to abandon it as soon as he observes private negative information. While at-the-money options are effective in inducing effort, they fail to induce good abandonment decisions in the sense that they bias the CEO in favor of continuing the project. When the CEO is free to unload (vested) stock options at will, he will do so whenever he learns bad news about the project. This behavior is beneficial to shareholders because after cashing out his options, the CEO is no longer biased, and hence is willing to abandon bad projects