Designing an Option Plan that Rewards Relative Performance: Indexed Options Revisited

This paper examines how an option plan that rewards managers for firm performance relative to some market or industry benchmark should be structured. Relativeperformance-based compensation advocates contend that conventional stock options do not adequately discriminate between strong and weak managers, typically suggesting “indexed options,” that is, options with an exercise price linked to a market or industry index, as a remedy. A close examination of indexed options, however, reveals a fundamental problem: indexed options do not function as its proponents intend. Instead, their payoff remains highly sensitive to market or industry price movements. This paper proposes an alternative option design, an option on a “performance-benchmarked portfolio,” that does remove the effects of the specified market or industry benchmark from the value of the option. This structure uses an option with a fixed exercise price, where the underlying asset is a portfolio comprised of the firm’s stock hedged against market and industry price movements.