RISK-AVERSE EXECUTIVES, MULTIPLE COMMON RISKS, AND THE EFFICIENCY AND INCENTIVES OF INDEXED EXECUTIVE STOCK OPTIONS

We extend research on executive stock options in two ways. First, we generalize Johnson and Tian's (Journal of Financial Economics, 57 (2000b)) single indexed executive stock option to incorporate multiple common risks. Second, we use an expected utility framework to analyze the efficiency and incentive effects of traditional and indexed option grants for risk-averse executives. If firms grant equal numbers of each option type and adjust their moneyness to provide equal utility to executives, single and multi-indexed option grants are less expensive than traditional options while providing stronger incentives to increase stock price. If firms adjust the number of options granted instead of their moneyness to produce equal utility, indexed option grants are more expensive than traditional grants. For firms facing multiple common risks, multi-indexed options are less expensive and provide stronger incentives to increase stock price than single indexed options.