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Annals of Finance
Published in: Annals of Finance 3-4/2015

01-11-2015 | Research Article

Evidence on exercise pricing in CEO option grants in two countries

Authors: Jean M. Canil, Bruce A. Rosser

Published in: Annals of Finance | Issue 3-4/2015

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Abstract

This paper examines the relationship between exercise prices, grant size and CEO risk aversion employing a data set of Australian option grants characterized by exercise prices that vary relative to the stock price. We argue that Australian exercise price and grant size decisions provide an appropriate framework for evaluating the consequences of the U.S. practice of granting at-the-money options. Using a 3SLS estimation, we find that exercise prices are positive in grant size when internalizing CEO risk aversion but less so for the U.S. relative to Australia. We find also that CEO risk aversion is negatively related to both exercise prices and grant size in Australia but negatively related only to exercise prices in the U.S. A positive relation found between CEO risk aversion and grant size in the U.S. implies that risk aversion is addressed with larger grant sizes to compensate for fixed exercise prices.
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Appendix
Available only for authorised users
Footnotes
1
Murphy (1999) reports that 94.8 % of option grants to U.S. CEOs in fiscal 1992 are granted at-the-money, with Banerjee et al. (2008) documenting that in 2005 99.92 % of option grants were granted at-the-money.
 
2
Issuing a non-qualified options (i.e., in-the-money on the grant date) may not be fully-deductible if the value of the non-performance-based compensation exceeds 1 million dollars. In addition, grants of non-qualified options are likely to result in the tax liability to the manager exceeding the tax benefit to the issuing company (Palmon et al. 2008). For financial reporting, pre-FAS 123R grants of in-the-money options were expensed, but not grants of at-the-money and out-of-the-money options.
 
3
Tang (2012) further argues that exercise prices should vary with the vesting period.
 
4
This is consistent also with Edmonds and Gabaix (2011) who show that risk aversion requires higher incentives to deliver a given effort.
 
5
Young and Quintero (1995) argue that out-of the-money grants are unpopular given that effort exerted by a risk-averse CEO contributes less to her expected utility than in-the-money grants at the same cost. Palmon et al. (2008) further note that in-the-money grants are rare due to mandated expensing and taxation of the difference between the fair market value of the underlying and the exercise price for non-qualified options.
 
6
Australian executive stock option plans are partially surveyed in Taylor and Coulton (2002) while U.S. executive stock option plans are surveyed in Hall (1999).
 
7
For example, North Limited, ICI Australia Limited and Ashton Mining Limited prescribed an exercise price being the average of the stock price for the prior 5 trading days, with some companies (e.g., Energy Equity Limited) adding a requirement for a premium to market and others (e.g., Orbital Engine Limited) adding a requirement for a discount. Amcor Limited and BRL Hardy Limited, for example, granted full discretion to their compensation committees.
 
8
The recent history of Australian tax provisions in relation to executive option grants and coincident with our sample period is documented in Grigaliunas and Trainor (2001). The U.S. system is outlined in Murphy (1999). In-the-money grants are not considered performance-based compensation in accord with Section 162 (m) of the Internal Revenue Code and are therefore not tax deductible if an executive’s total non-performance-based compensation exceeds $1 million in a given year. At the same time, prior to the introduction of FAS 123R in 2005 only in-the-money options were expensed in the income statement.
 
9
See, for example, the Income Tax Assessment Act, division 83A as amended in 1997.
 
10
Since grants are typically approved by shareholders at Annual General Meetings grants made within 5 months after the close of the preceding fiscal year are associated with that year (Corporations Act, sec. 250N). About half our grants are dated within this 5-month interval; the remainder are dated within the 7-month interval prior to the current fiscal year-end.
 
11
We also measure moneyness using a 5 % threshold. The results are qualitatively similar and available on request.
 
12
Given Australian and U.S. CEOs have similar equity-based compensation (refer Table 1) we assume the wealth of Australian CEOs is likewise similar (Conyon et al. 2011).
 
13
We perform a Hausman test (not reported) which fails to detect endogeneity in either set of estimations.
 
14
We would like to thank an anonymous referee for this suggestion.
 
15
Ownacc dummy is negatively correlated with Cash-to-stock \((r = -0.182, p=0.000)\) as expected, but is unrelated to CEO ten_age.
 
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Metadata
Title
Evidence on exercise pricing in CEO option grants in two countries
Authors
Jean M. Canil
Bruce A. Rosser
Publication date
01-11-2015
Publisher
Springer Berlin Heidelberg
Published in
Annals of Finance / Issue 3-4/2015
Print ISSN: 1614-2446
Electronic ISSN: 1614-2454
DOI
https://doi.org/10.1007/s10436-015-0262-4

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