Enhancing managerial equity incentives with moving average payoffs

• Author: Yisong S. Tian
• Published date: 01 October 2020
• DOI: http://doi.org/10.1002/fut.22131
• Date: 01 October 2020

J Futures Markets. 2020;40:1562–1583.wileyonlinelibrary.com/journal/fut1562

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© 2020 Wiley Periodicals LLC

Received: 31 July 2019

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Accepted: 12 May 2020

DOI: 10.1002/fut.22131

RESEARCH ARTICLE

Enhancing managerial equity incentives with moving

average payoffs

Yisong S. Tian

Schulich School of Business, York

University, Toronto, Ontario, Canada

Correspondence

Yisong S. Tian, Schulich School of

Business, York University, 4700 Keele

Street, Toronto, ON M3J 1P3, Canada.

Email: ytian@schulich.yorku.ca

Funding information

Social Sciences and Humanities Research

Council of Canada, Grant/Award Number:

Insight Grant number 435‐2016‐1502

Abstract

Prior research suggests that Asian stock options provide stronger managerial

equity incentives than traditional stock options do, holding the cost of the option

grant constant. Although this is true on the grant date, it is not over the life of the

option grant. Very little of the initial advantage remains after 2 years because

Asian stock options have diminishing incentive effects over time. A simple

solution is to replace averaging over the option's life with averaging over a moving

window. We show that moving average options do not have the diminishing

incentive problem and are effective in preventing managerial gaming.

KEYWORDS

Asian stock options, executive stock options, managerial equity incentives, managerial gaming,

moving average, stock price manipulation

JEL CLASSIFICATION

G13; G30; J33

1|INTRODUCTION

Managerial equity incentives such as stock option grants have been widely adopted in executive compensation (e.g.,

Murphy, 2013). By aligning the interests of top executives with those of the shareholders, these equity incentives help to

resolve agency conflict in a corporate setting and motivate executives to maximize shareholders’wealth. Some studies

(e.g., Bebchuk & Fried, 2010; Chhabra, 2008; Fried, 2008; Leippold & Syz, 2007; Su & Wang, 2019; Tian, 2013) have also

advocated the use of Asian stock options as managerial equity incentives in lieu of traditional stock options. Collec-

tively, they argue that linking incentive pay to average stock prices provides a better alignment of interests between

executives and shareholders, is more cost effective, provides higher pay‐performance sensitivity (PPS), and is parti-

cularly effective for preventing managerial gaming of option payoffs via stock price manipulation or other opportunistic

means. Averaging provides incentives for management to pursue long‐term growth opportunities instead of value‐

destroying investments with higher short‐term profitability. In contrast, executives compensated with traditional stock

options may choose to pursue the latter because even a short‐term boost in stock price can substantially elevate the

payoff of these options (e.g., Narayanan, 1985).

In this paper, we re‐examine managerial equity incentives provided by Asian stock options in comparison with

traditional stock options. This is necessary because previous studies (e.g., Tian, 2013) evaluate the incentive effects of

these option grants only at the time the stock options are granted but not subsequently in the future. Since most stock

options are granted with a 10‐year term, it is important to find out if Asian stock options provide better incentives over

the entire life of the options. By evaluating PPS both initially on the grant date and afterwards, we provide a more

comprehensive assessment of managerial equity incentives provided by these options. Our analysis suggests that the

advantage of Asian stock options over traditional stock options is rather short lived and diminishes quickly over time. In

fact, Asian stock options lose most of the initial advantage after just 2 years and have comparable levels of incentives for

another couple of years subsequently. Thereafter, they provide weaker incentives than traditional stock options do, with

the disadvantage increasing over time. Given the 10‐year lifespan of most stock option grants, this means that Asian

stock options provide stronger incentives than traditional stock options for only about 20% of the option grant's life.

Why do Asian stock options lose their advantage over traditional stock options so quickly after the grant date? Our

analysis suggests that the primary reason is averaging stock prices over the option's entire life. As time goes by, the

payoff of Asian stock option becomes more and more certain. In 2 years after the grant date, the average price is more or

less “anchored”to the level reached at that point. Even a relatively large jump in stock price may not have much impact

on the option payoff unless the elevated price is sustained over weeks or months. This type of anchoring leads to

diminished incentive effects over time. In comparison, traditional stock options provide a much more consistent level of

incentives over the entire life of the option grant. Such differences between Asian and traditional stock options are

behind the dramatic change in relative incentive levels between them over time.

Does this mean linking equity pay to average stock prices is a bad idea? Not necessarily. Given that most executives

exercise their options approximately 6 years after receiving the option grant (e.g., Bettis, Bizjak, & Lemmon, 2005;

Carpenter, 1998), Asian stock options maintain their advantage over traditional stock options in the first half of the

options’effective life (until exercise). The early advantage may still be a good tradeoff for companies that adopt Asian

stock options for executive compensation. Nevertheless, Asian stock options are unlikely the panacea previous studies

suggest. It is no longer clear which of the two types, Asian or traditional stock options, is a better form of incentive pay.

Is there a way to ameliorate the problem of diminishing incentives associated with Asian stock options? The answer is

yes. We show that a simple and yet effective solution is to link option payoff to a moving average (MA) of stock prices (e.g.,

1‐year MA) instead of the cumulative average over the entire life of the option. Rather than granting Asian or traditional

stock options, companies should consider granting MA stock options to their executives. With a MA, the option's payoff is no

longer tied to stock prices in the distant past. Instead, it is determined by stock price movement in the most recent past over a

fixed window. This “refresh”feature allows MA stock options to maintain their incentive strength over time. In fact, we

show that MA stock options provide comparable incentives as traditional stock options do, both initially on the grant date

and subsequently in the future. Linking option payoff to MA stock prices thus solves the problem of diminishing incentives.

In addition, MA stock options retain the attractive feature of Asian stock options as an effective tool to fight managerial

gaming of stock option exercises. This is because the payoff of MA stock options is still based on average stock prices and

thus much more difficult to manipulate and less profitable to game. As a result, both Asian and MA stock options are less

vulnerable to opportunistic managerial gaming than traditional stock options are. By combining the attractive features of

both traditional and Asian option grants into a single payoff structure, MA stock options are a better form of incentive pay

than either alternative and improve interest alignment between senior executives and shareholders.

Our study contributes to the managerial equity incentives literature in three ways. First, we are the first to point out the

importance of consistent incentives over the life of the option grant. This is particularly so for nontraditional option plans such

as Asian stock option plans. Comparing incentives effects on the grant date would have led to the misleading conclusions that

Asian stock options provide stronger incentives than traditional stock options do. Second, we stress the importance of early

exercise in elevating the option's value to the executive and thus its incentive effects. Most previous studies ignore this early

exercise premium and focus on European stock options for technical simplicity. We show that these studies vastly under-

estimate the magnitude of the option grant's incentive effects. Finally, our study is the first is analyze the incentive effects of

MA stock options and shows that they are a better form of managerial incentives than either traditional or Asian stock options.

They not only maintain a consistent level of managerial incentives but are also effective in preventing managerial gaming.

The rest of the paper proceeds as follows. Section 2provides a description of MA stock options and their valuation

using least‐squares Monte Carlo simulation. Section 3evaluates the incentive effects of MA stock options in comparison

with traditional and Asian stock options, both initially on the grant date and subsequently in the future. Section 4

compares the risk incentives of the three types of stock option grants. Section 5provides an analysis of the vulnerability

of different types of option grants to managerial gaming. The final section concludes.

2|MA STOCK OPTIONS

MA‐based measures are ubiquitous in financial markets. For example, MA indicators are widely used in technical

analysis by stock traders as they believe averaging helps filter out noise in stock price fluctuations and pick up trend in

TIAN

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