Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 1

When Good Options Go Bad

When a company’s stock price falls and its executive stock options no longer look attractive, it has a number of choices. One is to simply reprice the options to a lower price that is more in keeping with the lower market price of the firm’s stock. Another choice is to grant new options that have a lower exercise price to replace the old.

Another approach is for the executive to hedge his or her own stockholding or stock options by buying “put” (right-to-sell) options on the firm’s stock in the open market. If the stock price falls dramatically, the executive can still sell the stock or exercise the options at the relatively favorable (“put”) price. This practice is very much like that engaged in by global firms to hedge their exposure to foreign exchange fluctuations.

The problem with executives hedging their stock holdings and options is that it undermines the principle of pay for performance. Through hedging, the executive can effectively protect against a fall in the stock. Hedging reduces the risk of stock ownership and therefore reduces the incentive for executives to take steps to sustain stock price.

Source: Brian J. Hall and Thomas A. Knox, “Underwater Options and the Dynamics of Executive Pay-to-Performance Sensitivities,” Journal of Accounting Research, May 2004, p. 365; and “GE: When Execs Outperform the Stock,” BusinessWeek, April 17, 2006, p. 74.

Step 1 of 2

Executive stock option is a contractual benefit given to selected employees of a firm where that get right to buy share or stock of the company at special price for specific number of years.