We study the effect of managerial behavior on the value and incentive effects of executive stock options. Such a study hinges critically on using a model wherein managerial behavior and firm value are endogenous, precluding the use of the Black-Scholes model. In our model, a self-interested manager makes an investment decision based on private information about investment opportunities. We show that when a call option’s value is $11.32 under an optimal investment policy, its value varies from $0 to $13.73, depending on the manager’s risk aversion and wealth composition. We also show that the manager’s delta is a poor proxy for incentives to invest or agency costs, and hence firm value. Managers of identical firms with nearly identical deltas may pursue vastly different investment strategies, due to differences in wealth composition and risk aversion.

Performance-based pay can be used to overcome the agency problems between managers and shareholders that arise due to the separation of corporate ownership and control (Jensen and Meckling, 1976). At the heart of this idea is the notion that executives can directly and significantly affect firm value. Yet the Black-Scholes formula (Black and Scholes, 1973)—the “gold standard” for valuing many types of options, including executive stock options—assumes an exogenous stochastic process for the value of the asset underlying the option. Thus, in a Black-Scholes world, an executive’s actions have no effect on his firm’s shares.

But, the value of executive stock options is inextricably linked to executive actions and firm value. If options didn’t affect managerial behavior and managerial behavior didn’t affect firm value, why would firms choose to grant executive stock options? The question, then, is not whether the assumption of an exogenous stock price process is violated, but rather how serious are the violations of this assumption? Our paper’s purpose is to assess the magnitude of this problem and its impact on compensation research.

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