It is well documented that executives granted stock options tend to exercise early and in a few large transactions or “blocks”. Standard risk-neutral valuation models cannot explain these patterns, and attempts to capture the exercise behavior of risk averse executives have been limited to the special case of one option. This paper solves for the optimal exercise behavior for a risk averse executive who is granted multiple stock options. We show that traditional utility-based models do not predict block exercise behavior. Rather, the risk averse executive exercises stock options individually at a sequence of increasing price thresholds. We give these thresholds in closed form. When, in addition, the executive exerts costly effort to exercise options, he faces a trade-off between exercising little and often to maximize return, and exercising larger quantities on fewer occasions to minimize effort. We find that as costs increase, options are exercised on fewer dates. The costly exercise utility-based model generates block exercise behavior and yields new predictions. In particular, executives should begin by exercising large blocks of options, but the block sizes should become smaller over time.

This paper examines whether CEOs are fired after bad firm performance caused by factors beyond their control. Standard economic theory predicts that corporate boards filter out exogenous industry and market shocks to firm performance when deciding on CEO retention. Using a new hand-collected sample of 1,590 CEO turnovers from 1993 to 2001, we document that CEOs are significantly more likely to be dismissed from their jobs after bad industry and bad market performance. A decline in the industry component of firm performance from its 75 th to its 25 th percentile increases the probability of a forced CEO turnover by approximately 50 percent. This finding is robust to controls for firm-specific performance. The result is at odds with the prior empirical literature which showed that corporate boards filter exogenous shocks from CEO dismissal decisions in samples from the 1970s and 1980s. Our findings suggest that the standard CEO turnover model is too simple to capture the empirical relation between performance and forced CEO turnovers, and we evaluate several extensions to the standard model.

Principal-agent theory suggests that a manager should be paid relative to a benchmark that removes the effect of market or sector performance on the firm’s own performance. Recently, it hasbeenarguedthatwedonotobservesuchindexationinthedatabecauseexecutivescanset pay in their own interests, that is, they can enjoy “pay for luck ” as well as “pay for performance”. We first show that this argument is incomplete. The positive expected return on stock markets reflects compensation for bearing systematic risk. If executives ’ pay is tied to market movements, they can only expect to receive the market-determined return for risk-bearing. This argument, however, assumes that executive pay is tied to bad luck as well as to good luck. If executives can truly influence the setting of their pay, they will seek to have their performance benchmarked only when it is in their interest, namely when the benchmark has fallen. Using industry benchmarks, we find that there is significantly less pay-for-luck when luck is down (in which case pay-for-luck would reduce compensation) than when it is up. These empirical results are robust to a variety of alternative hypotheses and robustness checks, and suggest that the average executive loses 25-45% less pay from bad luck than she gains from good luck. 2 1

This paper empirically investigates the impact of macroeconomic uncertainty on the spreads of credit default swaps (CDS). While existing literature acknowledges the importance of the levels of macroeconomic factors in determining CDS spreads, we show that the second moments of these factors—macroeconomic uncertainty—predict CDS spreads even in the presence of traditional macroeconomic factors such as the risk-free rate and the Treasury term spread.

We analyze factors driving exercise price policy for executive option plans (ESOPs), and their scope, in a country where firms are not subject to such tax and accounting considerations, that have seemed to led to a dominance of at-the-money options in the U.S. Our “unbounded ” data for Finland provides us with an excellent opportunity to investigate whether contract design is consistent with compensation theory. Our findings are largely consistent with predictions from the optimal contracting literature. The size of the plan is negatively related to Tobin’s Q and firm size, and positively related to proxies for monitoring costs, which also explain the probability for launching premium ESOPs. However, our results also show that the premium (out-of-the-moneyness) is negatively related to prior stock return and cash flow to assets, which may indicate higher managerial powers, leading to more in-the-money options, in well-performing firms. Finally, we also report a positive relationship between the premium and the length of the vesting period, indicating an effort to keep the incentives for the management from falling over time.

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Properly designed incentives should reward management if and only if it succeeds in increasing shareholder wealth. We show that conventional at-the-money stock options do not achieve this objective, because they allow management to benefit from value created before the options were awarded. Consequently the cost of the options can exceed any value created for shareholders, and management can even benefit from negative-NPV projects. We also find that with at-the-money options, dividends are undesirable to management unless the strike is adjusted while repurchases are quite favorable to management. These problems are solved by indexing the exercise price to the cost of capital, a type of option that has been discussed lightly in the practitioner literature. Empirical estimates reveal that the difference in value between at-the-money options and options indexed to the cost of capital is about one-quarter percent of equity value but about 42 percent of option value and about 18 percent of total compensation. This figure is positively and significantly related to measures of free cash flow and overinvestment, as predicted by the model. If options are viewed strictly as incentives, this figure suggests a substantial waste of shareholder value, but if options are viewed as

Deregulation and the relationship between bank CEO compensation and risk-taking The deregulation of the banking industry during the 1990s provides a natural (public policy) experiment for investigating how firms adjust their executive compensation contracts as the environment in which they operate becomes relatively more competitive. Using the Riegle-Neal Act of 1994 as a focal point, we investigate how banks changed the equity-based component of bank CEO compensation contracts. We also examine the relationships between equity-based compensation and risk, capital structure, and investment opportunity set. Consistent with theoretical predictions, we find that after deregulation, the equity-based component of bank CEO compensation increases significantly on average for the industry. Additionally, we find that more risky banks have significantly higher levels of equity-based compensation, as do banks with more investment opportunities. But, more levered banks do not have higher levels of equitybased CEO compensation. Finally, we observe that most of these relationships become more powerful in our post-deregulation period. 2

WP 2003-32Deregulation and the relationship between bank CEO compensation and risk-taking by

1 Market based compensation, trading and liquidity This paper examines the role of trading and liquidity in a large competitive market with dispersed heterogenous information on market-based management compensation. The paper recognizes the endogenous nature of a firm’s stock price- it is the outcome of self-interested speculative trading motivated by imperfect information about future firm value. Using the stock price as performance measure means bench-marking the manager’s performance against the market’s expectation of that performance. Our main result is that the degree of market-based compensation is proportional to market liquidity, which is a measure of the ease of information trading. 2