Stock Options With Fixed Exercise Prices

Stock options With Fixed Exercise PricesTable of Contents (Jump to)1 intro2 Fixed Price Options versus tycooned Options3 contingency for Indexed Options3.1 Compensation for Relative rather than Absolute Performance3.2 Protection of Managers during Market Downswings3.3 Reduced Expected be4 Case against Indexed Options4.1 Unpredictability4.2 Difficulty in Controlling Compensations4.3 Larger Deadweight be.4.4 Tax Treatment4.5 Reluctance of Managers5 Reasons for Choosing Alternatives of Indexed Options5.1 Requirements of Firms5.2 Sensitivity of Payoff6 experiential Evidence7 Conclusion8 References1 IntroductionThe principal-agent problem has long been a question of handleion within organisational institutions. As a matter of fact, the owners of a limited comp any normally elect a Board of Directors to control the businesss resources on their behalf. However, conflict arises among these managers and shareholders collectable to their different objectives.As owners, shareholders w ould want to maximise profits while managers may want to maximise sales, build empire buildings and enthral perks. To align the interests of both stakeholders therefore, compensation of managers should be connect with the firms performance. One way to do this is the introduction of resources fixed monetary value options and forefingered options.Basically, an option is a financial derivative representing a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a particular worth on or before a certain date. An option, just like a credit line or bond, is a security.Fixed damage options and indexed options differ significantly from each other. For the purpose of this assignment, we will discuss how indexed options provide a better case compared to fixed outlay options.2 Fixed Price Options versus Indexed OptionsFixed wrong options whose reading price is already hold upon and will remain the same until expiration date. The opti on exercise price is usually set equal to the stock price at naming. When an executive director is disposed(p) a fixed price option as a means compensation, two situations can arise. If the share price rises above the exercise price, the executive gains. On the other hand, the executive receive absolutely slide fastener if there is a decrease in share priceIn contrast, an indexed option is a stock option whose exercise price is connected to a benchmark index, which may be a specific sector index or a wide market index. Indexed price options ache unknown selling price when contract is being made, and the final price of the option depends on market status on the expiration date. A change in the absolute value of the share will welcome no effect unless(prenominal) thecompanyoutperformssomestatedindex suchastheSP500 or a group of peers. then only, the optionwillbeexercised.3 Case for Indexed Options3.1 Compensation for Relative rather than Absolute PerformanceFixed price option s reward performance in absolute terms. If the share price increases, the executives are rewarded in spite of rising market trends being unconnected to managers performance. decision makers are still rewarded if competitors or the market have performed better. Similarly, when the share price falls, no rewards are given even if the firm did better than its peers.On the other hand indexed options reward relative rather than absolute performance. Hence, executives do not enjoy windfall gains by luck in rising markets, but by their performance instead. Only if the company performs better than the market or its peers that the executives can property in. The executives have therefore further incentives to deliver good performance.The example below gives a better idea of how indexed options actually reward relative performance.XYZ ltd.s legality stock is currently selling for $100 per share when the market (benchmark) index is at a level of 1000. XYZ limited grants an option to its chi ef executive officer which enables him to purchase an option consisting of 100000 shares at an exercise price of $100, but the same will move in line with the market in future. Taking a specific case, the CEO is given indexed options. The value of the option granted to the CEO under 4 various scenarios is shown in the table below.Value of Indexed Option under Indexed OptionsSHAREPRICE mightinessRisesFallsOutperforms the indexIndex 1150 (by 15%)Exercise price $115 (by 15%)Stock price $120 (by 20%)Value of option $500,000Index850Exercise price $85 (by 15%)Stock price $90 (by 10%)Value of option $500,000Underperforms the indexIndex 1150 (by 15%)Exercise price $115 (by 15%)Stock price $110 (by 10%)Value of option $0Index 850 (by 15%)Exercise price $85 (by 15%)Stock price $80 (by 20%)Value of option $0Table 1From Table1, indexed options only reward the CEO when the companies stock outperforms the market, even if indexes have increased or decreased. They have a fair way of rewarding CEOs they do not reward under-performingexecutives nor do they penalize superior performers whenever the market index has increased or decreased in respective cases. This is a convenient way of keeping CEOs motivated and thus encourage them perform well in their duties of decision making for a companys investment. In general, indexed options reward superior performance under all market conditions.However, if the same example is interpreted in the case of fixed price option, and that there is a 5% change in the share price, the scenarios will differ as followsValue of Option under Fixed Price OptionsSHAREPRICERISESExercise price $100Share price $105 (by 5%)Value of option $500,000EXERCISE OPTION goExercise price $100Share price $95 (by 5%)Value of option $0NOT EXERCISE OPTIONTable 2As shown in Table 2, when the share price increases from $100 to $105, the option is exercised to the benefit of the manager. The latter receives a compensation of $ 500,000. In the reverse case, when the shar e price falls to $95, the shareholders gets no compensation.3.2 Protection of Managers during Market DownswingsIn the case of fixed price options, executives are not rewarded when the market is declining because share prices are below the exercise price. However, indexed options can well reward managers in bearish markets as long as the decline in the companys stock price is less steep than that of his peers. Indexed options reward better performers.3.3 Reduced Expected CostsTraditional options plans reward employees as long as the share price is higher than the grant price. However, indexed options eliminates the possibility that managers can be compensated for share price movements that are unrelated to what they might have done. Thus it helps a firm to remove or lower undeserved compensations. A study by J. Angel and D. McCabe values that the outgo of providing conventional options to executives at the 100 big(p)st NYSE-listed companies is 41 percent more than the expense of pr oviding options that take out market outcomes. The lower expected be against future earnings of indexed options compared to fixed priced options can only be to the advantage of companies.4 Case against Indexed OptionsThe advantages of indexed options over fixed price options are flagrant in light of the above. However, the application of indexed options is still rare. They lag behind fixed price options in umteen ways.4.1 UnpredictabilityUnlike indexed options, fixed price options brings predictability and certainty to a transaction due to the fixed exercise price. Through the characteristic of all or nothing, the manager will exercise, and therefore make money, if and only if the firms stock price is above the exercise price.4.2 Difficulty in Controlling CompensationsBudgeting and anticipate business costs are made easier using fixed value plans. They allow for firms to plan and control how much compensation to offer to employees. Retention risk, in particular concerning non- ex ecutive staff members, can be largely minimised when compensations are close to that offered by rival companies. Indexed options, on the other hand, can cause large discrepancies in compensations and the loss of key employees.4.3 Larger Deadweight CostsAn indexed option plan has a greater deadweight loss compared to a traditional option plan. This is because, with agency problems, where the interests of owners and managers do not always line up, there is the need to expose the managers to firm-specific risk to encourage a specific type of behaviour. However, this means that they are unable to exchange their portfolios to their full potential, exposing them to both systematic and unsystematic risks while compensating them only for the systematic portion of risk. Consequently, managers will always value their equity-based compensation at less than its market value.4.4 Tax TreatmentSo as to obtain favourable tax treatments, a company can grant incentive stock options. However, accordi ng to the 1994 US Code, this entails that the option price should be less than the fair market value of the stock at the time such an option is granted. In this case, it implies that the option price be fixed on the grant date.4.5 Reluctance of ManagersManagers are unwilling to accept a compensation plan based on relative performance. This is because in the case of fixed price options, when the stock market performs well, they reap high rewards for stock price performance unrelated to their own efforts. Managers are reluctant to come before the potentially huge rewards conferred by the bull market, especially when they estimate that a downturn is less likely to occur in the stock market.5 Reasons for Choosing Alternatives of Indexed OptionsBesides, it should be noted that indexed options are not suitable in all cases. Some reasons are illustrated below and the corresponding utility(a)s are also suggested.5.1 Requirements of FirmsCompensation systems have the undermentioned functi ons to compensate managers for completed work, to reduce principal-agent costs by more closely aligning managers interests with those of shareholders, and to retain the manager. Compensation that accomplishes one of these functions successfully may not verbalize out the other functions of a compensation system as effectively. Stock options, for instance, serve to align incentives. However, a firm where incentive alignment is not that important, would not be keen to use stock or stock options to compensate its managers. It would rather use cash compensation Cash avoids the deadweight costs that accompany any equity-based compensation plan.5.2 Sensitivity of PayoffIndexed options do not work as expected in practice. Instead, their payoff tends to be highly sensitive to market price movements. As the market increases, the value of the variable-exercise-price option increases too. For example, Lisa Meulbroek of Harvard Business School shows that the estimated value of an option indexed to the SP 500 rises by 15% if that stock index rises by 15%. Clearly, indexing does not even achieve its aim separating the general market movements from the movements in the value of the option.An alternative design that rewards managers only for performance and not for that is due to overall gains in the market or industry can be considered. Instead of using the firms stock as an underlying asset, an alternative design employs a performance benchmarked portfolio. Under this proposed structure, the value of the portfolio changes to reflect the firms performance, net of market and industry effects, while the exercise price ashes fixed. (Meulbroek, 2001).6 Empirical EvidenceA brief empirical review will determine whether relative performance is compensated in practice. We also explore if indexed options are indeed better than fixed price options.According to Gibbons and Murphy (1990), chief executive officers are compensated upon relative performance. It was found that there is a positive and significant relationship between the remunerations of CEOs and the firm performance, but an inverse and significant one with the industry and market performance.On the contrary, Bertrand and Mullainathan (1999) report that CEOs are compensable for market-wide and industry movements that they perceive as luck. However firms that are better managed reward their CEOs less for such market movements compared to other firms. Sloan (1993)s also found that CEO compensation depends on earnings so as to help separate market movements from the reward.With regard to the effectiveness of indexed options, in their works titled Indexing Executive Compensation Contracts in 2013, Ingolf Dittmann, Ernst Maug and Oliver G. Spalt gave empirical evidence that indexed options provide incentives at a higher cost than conventional options.7 ConclusionIn light of the above, it is observe that stock options with fixed exercise prices do not properly link managers performance to compensation si nce they relate to absolute and not relative performance reward. Indexed options have higher incentive advantages over the fixed price option since it takes into account the skills of the executives. It is also highlighted that indexed options result in a lower compensation costs than combining weight fixed price options. Nevertheless, the drawbacks and suitability of indexed options should not be ignored either. As a result, a firm is well advised to properly weigh the costs and benefits of indexed options before applying them.8 ReferencesAngel, J. and McCabe, D. (2002). Market-adjusted options for executive compensation. Global Business and Economics polish up, 4(1), pp.123.Bebchuk, L. and Fried, J. (2004). Pay without Performance, The Unfulfilled Promise of Executive Compensation, Part III The Decoupling of Pay from Performance. 1st ed. ebook Harvard University Press, p.24. accessible at http//www.law.harvard.edu/faculty/bebchuk/pdfs/Performance-Part3.pdf Accessed 25 Sep. 2014 .Bertrand, Marianne, and Sendhil Mullainathan, (1999), Are CEOs Rewarded for Luck? ATest of Performance Filtering, (Princeton University, Mimeograph).Chandra, P. (2007). FINANCIAL MANAGEMENT. 1st ed. New Delhi Tata McGraw-Hill, pp.947- 949.Dittmann, I., Maug, E. and Spalt, O. (2013). Indexing executive compensation contracts. 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