Applied Economics, 2007, 39, 1185–1193

Selecting suitable compensation

plans of executive stock options
Ming-Cheng Wu
Department of Business Education, National Changhua University of
Education, Changhua 500, Taiwan, ROC
E-mail: mcwu@cc.ncue.edu.tw

Theoretical and empirical works have emphasized that executive stock

option plans play an important role in compensation management and
corporate governance owing to the incentives to increase firm stock price
and volatility levels. This study not only proposes models of executive
stock options and constructs value-matched financial variables for
comparing the incentive effects towards these options, but also develops
an empirical study exploring the characteristics of executive stock options
and suitable compensation management for companies. This investigation
examines the daily value and compares incentive effects of six kinds of
executive stock options with the empirical data of TSMC, the world’s
largest dedicated semiconductor foundry, which is listed on the TSE and
NYSE. Empirical results indicate that purchased options would be the best
choice for companies that are unsuitable to undertake risky investments,
while the relative indexed options are appropriate for bear markets and
good for companies whose executives are highly risk averse. Repriceable
options are not recommended due to their high costs and weak incentive
effects.

I. Introduction from 25 to 40% from 1992 to 1998. Business Week

even reported that percentage rose to 80% in 2001.
The main objective of executive stock option plans Profit-sharing and bonus-payment as instruments
(ESOP) is to eliminate agency problems between to improve productivity have been introduced in
executives and shareholders by granting executive many economies such as the USA, UK and Germany
stock options to reduce the risk-adverse degree of since the late 1970 s. In fact, these incentive instru-
executives (Carpenter, 2000; Johnson and Tian, ments also have worked in a centrally planned
2000b; Tian, 2004; Duan and Wei, 2005). As the economy like China (Yao, 1995; Coady and Wang,
option payoff depends on the firm stock price relative 2000). Many authors confirm that profit-sharing is a
to the strike price, ESOP also represents the executive good incentive to raise profitability and productivity
compensation schemes in which executive wealth (Hanlon et al., 2003; Peters, 2004). The compensation
results from their performance and contribution system ‘performance related pay’ (PRP) is linked in a
rather than from the fixed salary provided by the direct way to his/her output (Cowling, 2002).
company. Therefore, enterprises make use of the Besides, whether executive compensation
potentially huge profits obtainable through stock was loosely tied to shareholder wealth was strongly
options to attract employees. Hall and Murphy debated during the 1970s: risk-neutral shareholders
(2001) found that in S&P 500 listed companies, the prefer that executives invest in projects with
use of stock options to compensate executives rose positive NPV without considering their risk.
Applied Economics ISSN 0003–6846 print/ISSN 1466–4283 online ß 2007 Taylor & Francis 1185
http://www.tandf.co.uk/journals
DOI: 10.1080/00036840600592841
1186
However, risk-averse executives prefer positive NPV,
but low-risk projects to ensure their own status in the
company (Yang, 1994). Consequently, serious agent
problems arose between shareholders and executives.
Enterprises answered calls until the 1980s to tie
compensation more closely to shareholder wealth
through increasing the granting of executive stock
options. Due to the incentive effects of executive
stock options to increase stock price and firm risk,
discrepancies between the goals of shareholders and
CEOs could be gradually eliminated.
Executive stock options are the same as call
options and granting stock options symbolizes the
existence of an incentive compensation system linking
firm performance and employee salaries. By granting
stock options, companies give their employees the
right to purchase firm stock in a specified price, the
strike price. A typical executive stock option is always
granted at the money and has a 2 or 3-year vesting-
period. Executive stock options have been used as
part of executive compensation for many years.
Executive stock options create an incentive for
employees to increase firm stock price and risk.
Employees holding options can get exercise value
only by working hard to increase the stock price or
by investing in high risk and high profit projects
to create firm value. It is found that direct
incentive schemes have predicted effects and the
efficiency wage hypothesis is supported: compensa-
tion and work effort are positively correlated (Drago,
1991; Meulbroek, 2001; Hanlon et al., 2003).
The ESOP not only inspires employees to improve
firm operation and lift the stock price to obtain gains
in the future, but also enables executive target and
shareholder wealth to be closely tied to one another
to reduce agency problems. However, for share-
holders, even if dilution effects will arise when
options are exercised, the advantages of the incentives
still exceed the disadvantages caused by dilution
effects.
Since it is difficult to avoid the dilution effect in the
practice of ESOP, the phenomenon which increased
grants of executive stock options dilute stockholders’
equity has been disgusted by American investors after
American high-tech industry experienced the golden
decade of stock options in the 1990s. Johnson and
Tian (2000b) pointed out that during the long bull
market of the 1990s, traditional stock options with a
fixed strike price unfairly rewarded executives by
allowing them to benefit from a buoyant market
rather than from their own efforts. On the other
hand, due to the influence of uncontrollable systema-
tic factors the stock price could easily fall to make
options out-of-the-money in the bear market and it is
difficult to make options back to in-the-money.
M.-C. Wu
That is, executives can easily make a fortune with
little personal effort during the bull market but may
earn nothing despite working hard in a bear market.
To sum up, the traditional executive stock options
with a constant strike price fail to create the intended
incentive effects in bull and bear markets.
To overcome the shortcomings of traditional stock
options, nontraditional incentive contracts need to be
investigated. In fact, the nontraditional executive
stock options such as premium options, purchased
options, repriceable options and absolute indexed
option models proposed by Johnson and Tian
(2000a) and relative indexed stock options model
designed by Duan and Wei (2003). This study uses
the example of the largest dedicated semiconductor
foundry in the world, TSMC, to compare the issue
cost among the aforementioned traditional and
nontraditional stock options and also compares the
incentive effects based on the dollar value-equivalent
issue cost.
Not only does this work obtain more complete
empirical results regarding executive stock options,
but it also determines the suitable granting time,
advantages and disadvantages of the executive stock
options. Developing methods through which firms
can select stock options with low issue cost and
high incentive effects is also a major contribution
of this study.
The remainder of this article is organized as
follows: Section II proposes models of executive
stock options and constructs the value-matched delta
and vega for comparing the incentive effects toward
these options. Section III then develops an
empirical work to explore the characteristic of
executive stock options and the suitable compen-
sation management of companies. Finally, Section IV
summarizes the results.
II. The Model
Traditional stock options
When the options could be exercised, it seems that
executives own calls and can exercise options in the
fixed and stipulated strike price at any time before
the expiration date. Johnson and Tian (2000a)
called such options traditional stock options and
the exercise value is the stock price less the constant
strike price.
Since it is convenient to compute option value
using Black and Scholes (1973) (B–S) Model, B–S
and other related modified models are widely used
both in academic research and in capital markets.
Compensation plans of executive stock options 1187
Johnson and Tian (2000a) used the Black–Scholes– becoming a sunk cost if the option remains out of the
Merton (B–S–M) Model to estimate the value of money by the expiration date. The value of purchased
traditional stock options. Moreover, Conyon et al. stock options is given by
(2000) valued executive stock options granted to
CPPP ðSt , S0 ,
, f Þ ¼ CBS ðSt , S0 ð1
f Þ,
Þ
f  S0 ð3Þ
CEOs of UK companies in 1997 using the afore-
mentioned B–S–M Model. Additionally, Veld (2003) where f is the fraction of the strike price to be prepaid
used a sample of 17 Dutch companies to calculate the on the grant date.
value of employee stock options using the B–S–M
Model and compared the outcomes with the Dutch
fiscal rule. The B–S–M Model follows from the B–S Repriceable stock options. Callaghan et al. (2004)
(1973) Model modified for continuous dividends by pointed that when options go deep out of the money,
Merton (1973) and its model is given by the strike price should be reset downwards as a result
of the weak incentive effects existing at that time.
CðBSÞ ¼ St e
qS
Nðd1 Þ
S0 e
r
Nðd2 Þ Brenner et al. (2000) indicated that the authority
lnðSt =S0 Þ þ ðr
qS þ S2 =2Þ would generally reduce the strike price or extend the
d1 ¼ pffiffiffi ð1Þ maturity years to increase the value of stock options.
S

pffiffiffi Except in cases where firms have the right to reduce
d2 ¼ d1
S
the strike price if the firm stock price falls to the

¼T
t barrier price Bd during the life of the option, a
repriceable option is the same as a traditional one.
where t be the current date, T be the option maturity
The value of a repriceable stock option is computed
date and S0 and St be the stock price on the grant
by the following formula.
date (t ¼ 0) and date t, respectively. The continuous
dividend yield on the stock is qs, the instantaneous CRP ðSt , So , Bd ,
Þ
volatility rate on the stock is  s, the risk-free rate is r   v  2 
Bd Bd
and N() is the cumulative probability function of the ¼ CBS ðSt , S0 ,
Þ
CBS , S0 ,

St St
standard normal distribution.  v  2 
Bd B
þ CBS d , Bd ,

Nontraditional stock options St St
 v
Bd
¼ CBS ðSt , S0 ,
Þx þ
St
Premium stock options. Most companies grant   2   2 
executive stock options with at-the-money on the Bd B
 CBS , Bd ,

CBS d , S0 ,

grant date. Premium stock options have a higher St St
strike price when granted, so the value of the option is ð4Þ
reduced and the owners must make more effort to
2ðr
qS Þ
increase stock price before the option is in the money. where v ¼
1
Consequently, advocates of premium options claim S2
that stronger incentives to increase stock price are
created through the higher strike price relative to
traditional at-the-money options.
The value of premium stock options can be Absolute indexed stock options. With the long bull
computed by the B–S formula: market during the 1990s, market factors resulted in
large and widespread increases in stock prices and
Cpp ðSt , X,
Þ ¼ CBS ðSt , S0 ,
Þ ð2Þ
payoffs of traditional options. These circumstances
where X denotes the higher strike price on the created a system of unfair rewards in which the
grant date. contributions of executives to stock price increases
was rarely reflected accurately in the option payoffs
Purchased stock options. Executives are required to they received.
prepay a fraction of the strike price on the grant date Since traditional stock options cannot create
to get purchased stock options and pay the remainder sufficient incentive effects when deeply in or out of
upon exercise. Similar to traditional options, the the money, Akhigbe et al. (1996) proposed the idea of
payoff is the stock price less the strike price. indexing the strike price of executives’ options to the
Purchased stock options have lower issue costs and performance of a benchmark. The indexed options
can create stronger incentives to increase the stock proposed by Johnson and Tian (2000b) pay only if
price due to the possibility of the prepaid amount the firm stock price exceeds the specified moving
1188 M.-C. Wu
benchmark stock price. Therefore, the option payoff Variables of incentive effects – delta and vega. Delta
might be positive in bear markets or worthless in is defined as the partial derivative of option price with
bull markets. Furthermore, the indexed options respect to the underlying stock price. So it represents
also filter out the influence of common factors that the change in option value as the stock price
beyond the control of executives and create strong changes. Compared with the executive stock options,
incentives for option-owners to increase stock price the larger delta of the option is, the incentive to
and firm-specific risk. Duan and Wei (2003) increase the firm’s stock price is greater. That is,
termed the indexed options designed by Johnson larger deltas imply larger increases in executive
and Tian (2000b) the absolute indexed stock wealth for a given increase in firm’s stock price and
options. The value of absolute indexed stock options imply stronger incentives to make efforts.
is given by This study uses delta0 as the incentive parameter
for one unit stock options and adjusts comparative
CI ðSt , S0 , It , I0 ,
Þ ¼ e
qS
½St Nðd1I Þ
Ht Nðd2I Þ ð5Þ statistics to match the dollar value-equivalent mea-
where sure. Every delta0 of nontraditional stock options
  multiplies a different number of contracts, which
It
Ht ¼ S0 et makes its value equal to the traditional option on the
I0
grant date and the adjusted delta of different types of
s
¼ options will be compared.
I On the other hand, the vega is defined as the partial
1 derivative of option price with respect to the firm
 ¼ ðr
qS Þ
ðr
qI Þ þ s I ð1
Þ
2 volatility. Compared with the executive stock options,
lnðSt =Ht Þ þ ð1=2Þa2
larger vegas imply larger increases in executive wealth
d1I ¼ pffiffiffi
a
for a given increase in firm’s volatility, and thus imply
pffiffiffi
d2I ¼ d1I
a
stronger incentives to increase firm risk.
pffiffiffiffiffiffiffiffiffiffiffiffiffi The value of vega means whether executives will
a ¼ s 1
2 adopt high risk and high profit investment projects.
where It and I0 are the values of the index at time t Hence, if the option has a larger vega, it means
and 0, respectively, qI is the dividend yield on the that the incentive to increase firm risk and the
index,  s and  I are the volatility rate of the stock and effect of eliminating agency cost are both greater.
the index and  is the correlation coefficient between Accordingly, this study uses the value-matched vega0
the stock and the index. to compare the incentives to increase firm risk. Delta
and vega can be computed according to the following
formulas.
Relative indexed stock options. Meulbroek (2001) DeltaðBSÞ ¼ e
qS
N½d1 ðSt , S0 ,
Þ ð7Þ
pointed out that the indexed stock option pricing
model developed by Johnson and Tian (2000b) has Delta0 ðPPÞ ¼ e
qS
N½d1 ðSt , X,
Þ ð8Þ
the homogeneous function of degree one, making the
option payoff change by the same percentage when Delta0 ðPPPÞ ¼ e
qS
N½d1 ðSt , S0 ð1
f Þ,
Þ ð9Þ
both the stock price and the benchmark index
increase or decline simultaneously and at the same Delta0 ðRPÞ
rate. Hence, the absolute indexed option pricing   2 
model rewards executives too generously and pun-
qS
vBvd Bd
¼e N½d1 ðSt , S0 ,
Þ
vþ1 CBS , Bd ,

ishes them too harshly. St St
 2   vþ2
Duan and Wei (2003) improved the aforemen- B Bd
tioned pricing model and measured the value of
CBS d , S0 ,

e
qS

St St
indexed options using a homogeneous pricing model    2 
B
of zero degree, named the relative indexed stock  N½d1 ðBd , St ,
Þ
N d1 d , S0 ,
ð10Þ
option. They claimed that relative indexed options St
have stronger incentive effects and reward more
fairly. The value of relative indexed stock option is Delta0 ðIÞ ¼ e
qs
Nðd1 IÞ ð11Þ
given by
   H0 eðr
qs Þt
Delta0 ðI
RÞ ¼ Delta0 ðIÞ ð12Þ
St H
CI
R ¼ H0 ert
qS T  Nðd1I Þ
Nðd2I Þ ð6Þ pffiffiffi
r
t 0
Ht VegaðBSÞ ¼ S0
e N ½d2 ðSt , S0 ,
Þ ð13Þ
Compensation plans of executive stock options 1189
pffiffiffi an 8-year life. Except where noted, all other data
Vega0 ðPPÞ ¼ X
e
r
N0 ½d2 ðSt , X,
Þ ð14Þ come from the Taiwan Economic Journal (TEJ).
pffiffiffi
Vega0 ðPPPÞ ¼ S0
ð1
f Þe
r
N0 ½d2 ðSt , S0 ð1
f Þ,
Þ
ð15Þ Parameter estimation. First, St is the daily close
stock price of TSMC and S0 is the close stock price
pffiffiffi on the date when the option becomes exercisable. The
Vega0 ðRPÞ ¼ S0
e
r
N0 ½d2 ðSt , S0 ,
Þ
    strike prices of six kinds of executive stock options
4ðr
qS Þ Bd v Bd then can be obtained as follows: (i) The strike price

3
ln
S St St of traditional option is S0, $47 per share. (ii) The
  2   2  strike price of premium option is defined as 110%
B B
 CBS d , Bd ,

CBS d , S0 ,
of S0, $51.7. (iii) The purchased option has the same
St St strike price as the traditional ones’, $47. (iv) The
 v 
Bd pffiffiffi
r
repriceable option has an original strike price of $47,
þ
e Bd N0 ½d2 ðBd , St ,
Þ which is reset to $42.3 until the stock price declines
St
  2  to the barrier price Bd $42.3, 90% of S0. (v) With
0 Bd regard to the absolute and relative indexed stock

S0 N d2 , S0 ,
ð16Þ
St option, the strike price is tied to the TSE Electronic
Subindex.
pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi   

qs
2 0  It For the purchased option, the prepay fraction f is
Vega0 ðIÞ ¼ Ht e ð1
 Þ
N ðd2I Þ
ln defined as 5% prepayment of the strike price, S0.
I I0
   Moreover, the TSE Electronic Subindex It is chosen
1 2 
þ t I
 s
ðr
qI Þ Nðd2I Þ as the benchmark index for the indexed options. The
2 I
risk-free interest rate refers to the 1-year deposit
ð17Þ interest rate of the Taiwan Bank, 1.525%. Finally, the
 s,  I refer to the SDs of the return on TSMC stock
H0 eðr
qs Þt and the benchmark index, measured in the interval of
Vega0 ðI
RÞ ¼ Vega0 ðIÞ
Ht [
120,
1]. That is, the estimation period comprises
   1
 It a period of 120 days before the option becomes

CI
R ln þ t I
2 s exercisable.
I I0 2



ðr
qI Þ ð18Þ
I Empirical results
where Value differences across these executive
stock options. The value of an executive stock
lnðx=yÞ þ ðr
qS þ ð1=2ÞS2 Þz
d1 ðx, y, zÞ ¼ pffiffiffi option equals the revenue obtained by the issuer
S z when the option is sold to an outside investor.
pffiffiffi
d2 ðx, y, zÞ ¼ d1 ðx, y, zÞ
S z Consequently, larger option value implies greater
lnðSt =Ht Þ þ ð1=2Þa2
issue cost for the issuing company. This study
d1I ¼ pffiffiffi examines the per unit and everyday values of one
a

pffiffiffi traditional and five nontraditional executive stock
d2I ¼ d1I
a
options: premium options, purchased options, repri-
1 x2
ceable options, absolute indexed options and relative
N0 ðxÞ ¼ pffiffiffiffiffiffi e
2
2 indexed options, using empirical data of TSMC from
22 August 2004 to 31 March 2005, to provide
reference materials on granting executive stock
options taken as the important role on the compen-
sation management.
III. Data and Empirical Results
Figure 1 shows option values for the traditional
and nontraditional options plotted across a range of
Data
TSMC stock price levels. Except for the absolute and
This study uses the empirical data of the executive relative indexed options, other option values increase
stock options issued by TSMC on 22 August 2002, significantly with the stock price and the descending
which are exercisable until 22 August 2004, owing to orders are the repriceable option, the traditional
the 2-year vesting period. Besides, these options have option, the premium option and the purchased
1190
option. The above phenomenon can be explained
as follows:
Owing to the right to reset the lower strike price,
the issue cost of repriceable option is the highest.
As premium option is out-of-the-money when
granted, its value is smaller than traditional at-the-
money options. Regarding purchased options, execu-
tives must prepay 5% of the strike price to acquire the
purchased right and thus the purchased options are
Ct(BS) Ct(PP) Ct(PPP) Ct(RP)
Option value
55
51
47
43
39
35
40 43 46 49 52
Fig. 1. The value of six executive stock options
Notes: Comparison of option values for traditional and
nontraditional executive stock options over the stock price
of TSMC. Except where noted, the following model
parameters are fixed, with risk-free interest rate of
1.525%, and maturity of eight years. The strike price of
traditional options is $47, compared to $51.7 for premium
options. The purchased options require the owner to
prepay 5% of the strike price of $47. Meanwhile, the
repriceable options have their strike price reduced to $42.3
if the stock price declines to $42.3. As for the two types
of indexed options, their strike price is based on
the TSE Electronic Subindex, which is 222.12 on the
starting date of option exercisable. BS ¼traditional option,
PP ¼ premium option, PPP ¼ purchased option, RP ¼
repriceable option, I ¼ absolute indexed option, and
I-R ¼ relative indexed option.
M.-C. Wu
much less valuable than traditional options. That is,
the issue costs of purchased options are lower.
The option values of two types indexed options and
the stock price do not change in the same direction
because they are valued based on the performance of
TSMC relative to the benchmark and their values are
close, both being higher (lower) than the purchased
option at lower (higher) stock price level. Besides,
as shown in Table 1, both the values of the absolute
and relative indexed options increase or decrease with
the better or worse relative performance of TSMC.
Nevertheless, the rate of change of the absolute
Ct(I) Ct(I-R)
indexed option value is always larger owing to its
homogeneous function of degree one, so the absolute
indexed options may reward too generously and
punish too harshly.
To summarize, the issue cost for per unit purchased
options, absolute or relative indexed options, would
be lower than the other three types of options.
Moreover, the two indexed options have lower issue
cost at higher stock price level. Repriceable options
always cost more than other types of options and the
issue cost of premium options is smaller than that of
traditional ones.
Stock price of TSMC
Differences in the incentive effects to
55 58 increase stock price. According to Jensen and
Meckling (1976), the agency cost arises from the
difference between the objectives of executives and
stockholders. Theoretical and empirical studies of
agency problems recognize that granting executive
stock options can help to avoid it due to the incentive
effects of stock options. Anderson et al. (2000)
demonstrated that a significant positive correlation
exists between firm stock return and grants of
executive stock options and the level of the incentives
positively influences firm performance. Gibbs et al.
(2004) also found a strong positive relation among
the bonuses, productivity and profitability.
The delta of an option measures the rate of change
of the option price with respect to stock price. Larger
deltas imply larger increases in executive wealth for a

Table 1. The relative performance of TSMC and changes of indexed stock options
TSMC’s Benchmark Return rate Return rate TSMC’s relative
Date stock price index of TSMC of index performance C(I ) C(I-R)
C(I )
C(I-R)
04/08/23 47 222.12 2.34% 1.43% Better relative performance 44.655 44.655 2.13% 0.58
04/08/30 48.1 225.29 45.604 44.915
04/10/06 45 224.83
5.56%
5.26% Worse relative performance 42.136 41.734
6.40%
0.34%
04/10/15 42.5 213 39.439 41.592
05/02/17 53.5 232.19 2.80% 2.28% Better relative performance 43.849 42.051 3.66% 0.85%
05/02/25 55 237.49 45.454 42.409

Notes: C(I) is the value of the absolute indexed option; C(I-R) is the value of the relative indexed option.
denotes the rate
of change.
Compensation plans of executive stock options
given stock price increase and thus imply stronger
incentives to exert effort. Figure 2 shows that
excluding the two types indexed options, the descend-
ing orders in terms of the value-matched deltas are
the purchased option, the premium option, the
traditional option and the repriceable option.
The main reason for the aformentioned ordering is
as follows: first, the deltas of the purchased options
are significantly larger than those of other options.
The executives be required to prepay a fraction of the
strike price on the grant date to receive the options.
If the stock price remains below the exercise price by
the expiration date, the executives will lose the entire
advance payment. Consequently, the purchased
option creates stronger incentives to increase the
stock price through hard work. Second, the premium
option has a higher strike price than the traditional
one at the granted date, so the executives should
make greater efforts to increase the stock price.
Finally, the repriceable option owners have the right
to reset the strike price below that for traditional
options when the firm stock price falls to a barrier
Delta(BS) Delta(PP) Delta(PPP) Delta(RP) Delta(I)
Option delta
1.15
1.10
1.05
1.00
0.95
0.90
Stock price of TSMC
0.85
40 43 46 49 52
Fig. 2. The incentive to increase stock price
Notes: Comparison of option deltas for traditional and
nontraditional executive stock options over the stock price
of TSMC. Except where noted, the following model
parameters are fixed, with risk-free interest rate of
1.525%, and maturity of eight years. The strike price of
traditional options is $47, compared to $51.7 for premium
options. The purchased options require the owner to
prepay 5% of the strike price of $47. Meanwhile, the
repriceable options have their strike price reduced to $42.3
if the stock price declines to $42.3. As for the two types
of indexed options, their strike price is based on the
TSE Electronic Subindex, which is 222.12 on the
starting date of option exercisable. BS ¼ traditional
option, PP ¼ premium option, PPP ¼ purchased option,
RP ¼ repriceable option, I ¼ absolute indexed option, and
I-R ¼ relative indexed option.
1191
price. Therefore, the executives lack the motivation to
increase the stock price.
Regarding the two types of indexed options, the
deltas of indexed options are much larger at lower
stock price levels than at higher levels. When the
stock prices are lower, relative indexed options create
stronger incentives to increase stock price than
absolute indexed options and the other three option
types because the values of indexed options only
decline with worse relative performance and eliminate
the influence of uncontrollable systematic factors.
Oppositely, the incentive effect of the relative indexed
options is weakest at higher stock price levels. For the
same reason, indexed option values increase with
better relative firm performance. Executives who own
indexed options thus face difficulty in increasing
their wealth at higher stock price levels, especially
for relative indexed options. Accordingly, indexed
options create weaker incentives to increase stock
prices in bull markets.
From the comparison with the value-matched
deltas for executive stock options, the purchased
option creates the strongest incentive to increase
stock price regardless of stock price changes. In a
bear market, the two indexed options can also be
Delta(I-R) used as superior instruments due to the larger deltas,
especially the relative indexed options.
Differences in the incentive effects to
increase stock return volatility. Defusco et al.
(1990) pointed out that 60% of the sampled
companies have significantly larger stock return
volatilities after carrying out ESOP. Rajgopal and
Shevlin (2002) also found evidence that risk incentive
of executive stock options has a positive relation with
future exploration risk taking. Eisenmann (2002)
demonstrated that firm risk increased with executive
ownership of firm stock and options. That is, grants
of stock options can provide executives with an
incentive to increase firm risk.
55
The vega of an option is defined as the rate of
change of the option price with respect to the
volatility of the firm’s stock price. Larger vegas
imply larger increases in executive wealth for a given
increase in volatility and thus imply stronger incen-
tives to increase firm risk.
Figure 3 contains value-matched vegas for tradi-
tional and nontraditional options with a range of
volatility levels. The descending orders can easily be
determined based on the vegas and is as follows: the
relative indexed option, the absolute indexed option,
the purchased option, the premium option, the
traditional option and the repriceable option. Most
nontraditional options can create stronger incentives
to increase firm risk than the traditional option, with
1192
Vega(BS) Vega(PP) Vega(PPP) Vega(RP) Vega(I) Vega(I-R)
Option vega
7.0
6.
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5 Volatility
0.0
1.5 1.8 2.1 2.4 2.7
Fig. 3. The incentive to increase firm risk
Notes: Comparison of option vegas for traditional and
nontraditional executive stock options over the volatility of
TSMC. Except where noted, the following model para-
meters are fixed, with risk-free interest rate of 1.525%, and
maturity of eight years. The strike price of traditional
options is $47, compared to $51.7 for premium options.
The purchased options require the owner to prepay 5% of
the strike price of $47. Meanwhile, the repriceable options
have their strike price reduced to $42.3 if the stock price
declines to $42.3. As for the two types of indexed options,
their strike price is based on the TSE Electronic Subindex,
which is 222.12 on the starting date of option exercisable.
The legend is as follows: BS ¼ traditional option,
PP ¼ premium option, PPP ¼ purchased option,
RP ¼ repriceable option, I ¼ absolute indexed option, and
I-R ¼ relative indexed option.
the exception of the repriceable option and all their
vegas decline with increasing firm risk, implying that
these options do not still create the same strong
incentives to inspire executives to invest in risky
projects in situations involving high firm volatility.
To sum up, excluding the repriceable option and
taking the value-matched vegas into account, the
different kinds of nontraditional options exhibit
stronger incentive effect of increasing firm risk and
reducing agency costs than the traditional one,
especially the relative and absolute indexed options.
Meanwhile, the ‘expensive’ repriceable option could
not solve the agency problem efficiently.
IV. Summary and Implications
Executive stock option plans was adopted in the
1980s for linking executive and shareholder wealth
to eliminate the agency cost. With increased grants
of stock options, whether the nontraditional options
should be granted and can create stronger incentives
to increase the stock price and firm risk deserves
M.-C. Wu
further investigation. This study examines the incen-
tive effects of six types of executive stock options,
including traditional options, premium options,
purchased options, repriceable options, absolute
indexed options and relative indexed options.
The main contribution of this work is to suggest
the suitable types of executive stock options for use
by companies wanting to establish the compensation
plans. In addition to TSM, the other Taiwan’s
listed companies tallied with this study’s request
have the consistent results with TSM. The results
indicate that when firm stock price is lower, the
purchased option has the lowest issue cost.
Additionally, it creates the strongest incentive to
3
increase firm stock price and has larger vegas than
the traditional option.
The unit-value of two kinds of indexed options is
slightly less than that of purchased options at higher
stock price levels and both of their value-matched
deltas are inferior to the purchased options, but
their incentive effects to increase firm risk are much
stronger, especially for the relative indexed option.
Furthermore, repriceable options not only cost more
to grant, but also have the weakest incentives no
matter to increase stock price or firm risk.
To summarize, for companies that are unsuitable
to undertake risky investments, the purchased
options provide the optimum tool for compensation
management. Besides, though absolute and relative
indexed options separately cost more than purchased
options in bear markets, indexed options still have
stronger incentive effects than traditional options.
Furthermore, the value matched vegas of indexed
options are much larger than those of other options,
especially the relative indexed options. Consequently,
indexed options are suitable for granting in bear
markets and are good for companies whose execu-
tives are seriously risk averse. Meanwhile, repriceable
options are not recommended owing to the company
faces high compensation costs but obtains weak
incentive effects.
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