Review of Accounting Studies, 6, 7–28, 2001
2001 Kluwer Academic Publishers. Manufactured in The Netherlands.
Incentive Efﬁciency of Stock versus Options
GERALD A. FELTHAM AND MARTIN G. H. WU
Faculty of Commerce and Business Administration, University of British Columbia, 2053 Main Mall, Vancouver,
British Columbia, Canada, V6T 1Z2
Abstract. This paper examines the relative incentive costs of using stock versus options in management incentive
contracts that use market price as the performance measure. We establish that if the manager’s effort has little or
no effect on a ﬁrm’s operating risk, then the cost of incentive risk is less using stock rather than options. However,
this result is reversed if the manager’s effort has a signiﬁcant impact on the ﬁrm’s operating risk.
Keywords: Incentive efﬁciency, employee stock options, executive compensation
A ﬁrm’s stock price is often used as a performance measure in determining management
compensation because incentive devices based on the stock price directly align manage-
ment’s interests with the equity-holders’ desire to maximize the value of their shares. We
classify these incentive devices as either stock- or option-based. The stock-based devices
include restricted stock grants, phantom stocks, and performance shares; their key feature
is that the manager’s compensation is a linear function of the ﬁrm’s stock price, whether
that price is high or low. The option-based devices include incentive stock options, non-
qualiﬁed stock options, and stock appreciation rights; their key feature is that the manager’s
compensation varies linearly with the ﬁrm’s stock price to the extent the price exceeds what
is often termed the strike or exercise price. Options shield the manager from the down-side
risk to which stock exposes the manager.
Many empirical studies of management compensation either ignore options or “lump”
them together with stock using their “market values” (the Black-Scholes model is often
used to value the options).
However, options obviously have incentive effects,and “relative
value” is at best a crude representation of the “relative strength” of the incentives provided
by stock and options.
This paper uses two simple models to examine the relative cost to
investors of using stock versus options to induce a given level of effort by a risk and effort
averse manager. We refer to this as an analysis of the “incentive efﬁciency” of stock versus
options, and it contributes to our understanding of the factors that affect a ﬁrm’s choice
of stock versus options in using the stock price as a performance measure. Our analysis
ignores other potentially important factors such as tax and reporting differences, and the
interaction with other performance measures such as accounting earnings.
Several analytical studies consider the use of stock price as a performance measure, but
often ignore options and focus on stock grants. The focus on stock grants is primarily
driven by the desire to keep the models relatively tractable and no consideration is given as
to whether options might bepreferred to stock.Our ﬁrst model has thesame basic features as
the models used in the earlier studies. In particular, the manager’s preferences are assumed
to be represented by his expected compensation, minus a personal cost of effort, minus a