The impact of CEO option grants on firm value: determinants of the effectiveness of option grants

The significance of stock options as a component of executive compensation has fluctuated dramatically over the past decade. The purpose of this study is to investigate determinants of the effectiveness of stock option grants. These option grants are considered to be effective if they accomplish their intended role of enhancing firm value by inducing risk-taking behavior. Using data from 2,349 firms that granted stock options to their Chief Executive Officer (CEO) between 1992 and 2001, the relationship between the options granted and subsequent firm value was examined. This study found no universal positive association between option grants and firm value. However, CEO incentive equilibrium, defined as stability in the CEO??????s stock and option portfolio sensitivity to stock price, was found to influence the association between stock option grants and firm value. The positive association between grants and firm value was evidenced for the sub-sample of firms that demonstrate disequilibrium in CEO incentives. This was not the case, however, for the CEO incentive equilibrium sub-sample. This finding indicates that the positive valuation impact of stock option grants is highest for those firms that demonstrate a trend of increasing CEO portfolio sensitivity to stock price. High CEO portfolio sensitivity to equity risk was not found to interact with grant sensitivity to equity risk in a manner that reduces firm value. Thus, this study did not find support for the hypothesis that, ceteris paribus, grants further reduce CEO diversification, and interact with portfolio sensitivity to reduce incentives for risk-taking. Consistent with Lambert, Larcker and Verrecchia (1991), however, a high level of uncorrelated wealth is found to interact with grant sensitivity to equity risk so as to increase the positive impact of grant sensitivity on firm value.