The Impact of Options Trading on the Use of Stock Price in CEO Compensation and Turnover Decisions

Project: Research

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Description

To motivate executives to take actions that maximize firm value, shareholders normally design compensation contracts by tying executives’ pay to stock price performance. With a growing use of stock and stock option in executive compensation contracts, stock price has played an increasingly important role in affecting executive actions. The increase in CEO exposure to stock prices, however, has had mixed results. In particular, several recent studies show that that large option packages increase the incentives for managers to manipulate their firms’ reported earnings (e.g., Bergstressera and Philippon, 2006). Bond, Edmans, and Goldstein (2012) suggest that the manager’s incentives to take real actions will depend on the extent to which they will be reflected in the stock price. If the stock price is not closely tied to firm value, the manager has weak incentives to exert costly effort to improve the firm’s fundamental value. Edmans (2009) argues that any agent that gathers information about fundamental value and impounds it into prices can improve managers’ ex ante decisions and thus real efficiency.In the last 40 years, the market for derivatives has experienced spectacular growth. The informational role of options in an asset pricing or market microstructure setting has been extensively studied in recent years. The existing literature generally support that option trading facilitates informed trading, which improves stock price informativeness. In this project, we examine the endogenous response of executive compensation contract to improved price informativeness via option trading. Specifically, built on Holmstrom and Tirole (1993)’s theoretical work, we hypothesize that the sensitivity of CEO’s wealth to stock price and the sensitivity of CEO’s annual cash compensation to stock price increase in the volume of option trading. We also predict that the sensitivity of CEO’s replacement decision to stock price increases in the volume of option trading. As the above hypotheses are developed from an efficient contracting perspective, we further expect that the above hypothesized positive impact of option trading on the reliance of stock price is more pronounced when corporate governance is more effective or managers are less entrenched.To our best knowledge, we are the first to study the impact of option trading on optimal contracting. Given the astonishing size of the derivatives market, it is important to understand how the trading of derivatives affects the market of the underlying securities and the real economy (Stulz, 2004). The growing importance of stock price in executive compensation contracting suggests an important incentive channel through which option trading could affect the real economy. We believe our topic is both important and timely.

Detail(s)

Project number9042152
Grant typeGRF
StatusFinished
Effective start/end date1/08/1422/01/18

    Research areas

  • Options trading,CEO compensation,CEO turnover,Optimal Contracting,