Question

With reference to the relationship between stock prices and options values, explain what boards of directors are trying to achieve when they award CEOs options as part of their executive compensation packages.

Answer 1

A derivative does not have a value of its own but derives its value from an underlying asset. This underlying asset may include stocks, bonds, commodities, gold and bullions or any other financial market instrument.

An option is a type of a derivative which gives the right or the priviledge to the option holders to exercise the contract only when it favours them.

Relationship between stock price and option values

As said earlier, options do not have a value of their own but derives their value from an underlying asset, stocks in this case. Stock prices are one of those seven factors on the basis of which options are valued. Therefore, stock prices do have an impact on the options value.

Options as a part of Executives compensation packages

Board of directors usually include Stock options as a part of CEO compensation packages. The basic motive behind this is to maximise the shareholders' wealth which is the most important objective of any organization. An option gives the right to the CEO to exercise the contract if company's stock prices rises but not lose if the prices fall because in that case he will simply not exercise the option contract. Thus even the risk averse CEOs are given this incentive to take risk and invest in more projects so that they may drive the stock prices up. Thereby, benefiting both themselves and the company. When CEOs are rewarded with options, their financial motives coincide with the organization's financial motives and CEOs try their best to increase the stock prices. An increased stock price will benefit both the CEO and the shareholders.