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Estimating the Cost of Executive Stock Options: evidence from Switzerland
Author(s) -
Drobetz Wolfgang,
Pensa Pascal,
Schmid Markus M.
Publication year - 2007
Publication title -
corporate governance: an international review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.866
H-Index - 85
eISSN - 1467-8683
pISSN - 0964-8410
DOI - 10.1111/j.1467-8683.2007.00612.x
Subject(s) - executive compensation , stock options , economics , stock (firearms) , econometrics , certainty , actuarial science , risk aversion (psychology) , financial economics , microeconomics , expected utility hypothesis , finance , mathematics , incentive , mechanical engineering , geometry , engineering
It is often argued that Black‐Scholes (1973) values overstate the subjective value 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 assess the value‐cost wedge of executive stock options. Even with low coefficients of relative risk aversion, the discount can be above 50 per cent compared to the Black‐Scholes values. Regression analysis reveals that the equilibrium level of executive compensation is explained by economic determinant variables such as firm size and growth opportunities, whereas the pay‐for‐performance sensitivity remains largely unexplained. Firms with larger boards of directors pay higher wages, indicating potentially unresolved agency conflicts. We reject the hypothesis that cross‐sectional differences in the amount of executive pay vanish when risk‐adjusted values are used as the dependent variable.