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On the Benefits of Allowing CEOs to Time their Stock Option Exercises
Volker Laux,
University of Texas at Austin
ABSTRACT. Boards of directors in corporations generally allow their CEOs to unload their vested stock and option packages at will. This discretion is costly to shareholders because it enables CEOs to exploit their inside information, which has an adverse ex ante effect on effort incentives. The current paper demonstrates a benefit of this practice that may outweigh the cost of diluted incentives. I shows that issued at the money, executive stock options are effective in inducing effort but fail to provide the right incentives regarding abandoning bad projects. In particular, at-the-money options bias CEOs towards continuing projects even when they learn unfavorable information. This problem can be alleviated by allowing CEOs to time their option exercises. In this case, executives will use their inside information to exercise stock options exactly in those states where the continuation bias induced by these options is most detrimental, i.e., in the event of bad news.
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