Stock Options With Fixed Exercise Prices

p atomic number 18ntage Options With immovable work Prices get across of Contents (Jump to)1 Introduction2 Fixed Price Options versus Indexed Options3 Case for Indexed Options3.1 honorarium for Relative rather than Absolute Performance3.2 protective covering of Managers during Market Downswings3.3 Reduced Expected cost4 Case against Indexed Options4.1 excitability4.2 Difficulty in Controlling Compensations4.3 Larger Deadweight Costs.4.4 Tax Treatment4.5 disinclination of Managers5 Reasons for Choosing Alternatives of Indexed Options5.1 Requirements of Firms5.2 Sensitivity of proceeds6 Empirical Evidence7 Conclusion8 References1 IntroductionThe principal-agent problem has immense been a matter of discussion within organisational institutions. As a matter of fact, the owners of a limited federation normally elect a Board of Directors to subordination the businesss resources on their behalf. However, conflict arises among these managers and sh areholders payable to their diffe rent objectives.As owners, tradeholders would want to tap profits while managers whitethorn want to maximise sales, build empire buildings and enjoy perks. To align the interests of both stakeholders therefore, payment of managers should be linked with the firms performance. One way to do this is the entre of pickaxes fit(p) damage resources and world powered options.Basically, an option is a financial derivative representing a contract that gives the buyer the right, but non the obligation, to buy or care an netherlying as collide with up ones mind at a specific cost on or before a certain date. An option, just like a hackneyed or bond, is a security.Fixed impairment options and indexed options differ importantly from each other. For the purpose of this assignment, we will discuss how indexed options provide a purify chance compared to opinionated expense options.2 Fixed Price Options versus Indexed OptionsFixed bell options whose execute bell is already agre ed upon and will go along the same until expiration date. The option deterrent example price is usually set equal to the variant price at grant. When an executive is given a fixed price option as a means pay, both situations bear arise. If the grant price rises above the exercise price, the executive gains. On the other softwood, the executive receive absolutely nothing 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 broad grocery index. Indexed price options contrive unknown interchange price when contract is being made, and the final price of the option depends on commercialise status on the expiration date. A change in the absolute think of of the share will have no ensnare un s feeble thecompanyoutperformssomestatedindex much(prenominal)astheSP calciferol or a group of peers. Then totally, the optionwillbeexercised.3 Case for I ndexed Options3.1 Compensation for Relative rather than Absolute PerformanceFixed price options recognise performance in absolute terms. If the share price increases, the executives are rewarded in spite of rising merchandise trends being unconnected to managers performance. executives are clam up rewarded if competitors or the market have performed wagerer. 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 congeneric 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 stub cash in. The executives have therefore further inducings to deliver good performance.The spokesperson below gives a better idea of how indexed options actually reward recounting performance.XYZ ltd.s equity stock is currently selling for $ degree centigrade per share when the market (benchmark) index is at a level of 1000. XYZ limited grants an option to its CEO 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 next. Taking a specific case, the CEO is given indexed options. The value of the option granted to the CEO chthonian 4 various scenarios is shown in the table below. mensurate of Indexed Option under Indexed OptionsSHAREPRICEINDEXRisesFallsOutperforms 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 $0 plank 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 reliable way of rewarding CEOs they do not reward under-performingexecutives nor do they punish superior performers whenever the market index has increased or decreased in respective cases. This is a convenient way of keeping CEOs motivated and hence encourage them perform rise 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 taken 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 moveExercise 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 gear case, when the share 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 remunerative for share price movements that are unrelated to what they exponent have done. Thus it helps a firm to remove or start undeserved compensations. A study by J. Angel and D. McCabe values that the write down of providing conventional options to executives at the 100 largest NYSE-listed companies is 41 percent much than the spending of providing options that take out market outcomes. The deject expected costs 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 many ways.4.1 UnpredictabilityUnlike indexed options, fixed price options brings predictability and proof to a transaction due to the fixed exercise price. Through the device 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 forecasting business costs are made easier using fixed value plans . They allow for firms to plan and carry how much compensation to offer to employees. Retention guess, in particular concerning non- executive 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 unavailing to diversify their portfolios to their full potential, exposing them to both brassatic and unsystematic risks while compensating them only for the systematic portion of risk. Consequently, managers will always value their equity-based compensation at less t han its market value.4.4 Tax TreatmentSo as to bewilder favourable tax treatments, a company can grant incentive stock options. However, according 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(prenominal) 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 forego 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. any(prenomina l) reasons are illustrated below and the corresponding alternatives are also suggested.5.1 Requirements of FirmsCompensation systems have the following functions 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 carry 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 progeny tends to be highly sensitive to market price movements. As the market increases, the value of t he 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, list 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 rudimentary asset, an alternative design employs a performance benchmarked portfolio. Under this proposed structure, the value of the portfolio changes to shine the firms performance, net of market and industry effects, while the exercise price remains fixed. (Meulbroek, 2001).6 Empirical EvidenceA design empirical review will determine whether relative performance is counterbalance in practice. We also explore if indexed options are indeed better th an 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 alliance 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 remunerated for market-wide and industry movements that they grasp 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 observed that stock options with fixed exercise prices do not the right way link managers performance to compensation since 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 equivalent 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 Review, 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. 1s t ed. ebook Harvard University Press, p.24. Available at http//www.law.harvard.edu/ qualification/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. Review of financial Studies, 26(12), pp.31823224.Gibbons, R. and Murphy, K. (1990). Relative performance evaluation for chief executive officers, Industrial and persistence Relations Review 43, 30-51Meulbroek, L. (2000). Executive Compensation Using Relative-Performance-Based Options Evaluating the Structure and Costs of Indexed Options. SSRN Journal, online 01-021. Available at http//dx.doi.org/10.2139/ssrn.281028 Accessed 21 Sep. 2014.Mueller, D. (2012). The Oxford handbook of capitalism. 1st ed. Oxford O xford University Press, p.386.Schnusenberg, O. and McDaniel, W. (2000). HOW TO VALUE INDEXED administrator STOCK OPTIONS. Journal of Financial and Strategic Decisions.Sloan, R. (1993). Accounting earnings and pop off executive compensation. Journal of accounting and Economics, 16(1), pp.55100.Stapledon, G. (2004). THE PAY FOR PERFORMANCE DILEMMA. 1st ed. ebook U of Melbourne Legal Studies Research Paper No. 83, p.6. Available at http//www.pay-without-performance.com/Stapledon-Pay-for-Performance-Dilemma .pdf Accessed 25 Sep. 2014.Symes, S. (2014). Advantages Disadvantages of a Fixed-Price Contract. online Small Business Chron.com. Available at http//smallbusiness.chron.com/advantages-disadvantages-fixedprice-contract-21066.html Accessed 23 Sep. 2014.