A Study On The Validity Of Incentive Stock Options Of Listed Companies

To keep the interest of shareholders and the interest executives consistent, the system of incentive stock options has been used. Incentive stock options come from the United States. Among the practice in the United States, there were the success of incentive stock options cases such as Silicon Valley high-tech enterprise application system.Meanwhile there was Enron financial fraud scandal related the equity incentive. While U.S academic field and practitioners were having a comprehensive reflection on the stock option incentive system, incentive stock options system was introduced to China for listed companies to solve the issue of the lack of long-term incentives. Although China has started the normative practice of incentive stock options since 2006, the conditions which do help incentive stock options to play validity are not adequate, the theory field and the practitioners lack of comprehensive and deep understanding on the executive's stock options and the mechanism of incentive stock option. The paper focuses on the study of the validity of incentive stock options from the position of the mechanism of executive stock option incentive. From theoretical and empirical studies, the paper analyzes the vulnerability of executive stock options and the instability of incentive mechanism, which tests the validity of incentive stock options. Last, the paper proposes some advice to improve the validity of incentive stock options. After the exordium and literature review, the body of the paper follows as:The validity of capital market is one of the prerequisites for the validity of incentive stock options. The paper analyzes the relationship between the capital market and executive's incentive stock options. We know that in theory the application of incentive stock options required the company's share price reflecting a company's value on the basis of the efficient market hypothesis and the efficient market classification theory. In practice, the individual company's share price can be affected by the trend of market and industry factors. Although there is greater volatility of stock price, stock price as performance indicator for the executive's incentive stock option is still necessary. If the stock price deviates from fundamental value of the company, it is difficult to judge the executive's hard work and output level, which would affect the holders of options to implement the equity-based compensation. The executive's stock option as a long-term incentive tool, which is different from traded options of market in the characteristics, can only be bullish, and but to accept. The end of its profit is zero, positive earnings is infinite. The time value of the value of the executive's stock option impels the executive to work hard to promote stock price and get more return from stock option. The models of pricing the stock option including the Black-Scholes model are on the assumption that investors are risk-neutral. The executives which are human capital to work and whose wealth is un-diversified are risk-averse. The risk-averse executives abate the option value priced by the Black - Scholes model .If the company granted the stock options to the risk-averse executives according to option value priced by Black-Scholes model but no risk premium, there would be insufficient in incentive intensity. Also because of the log-normal distribution of stock price, the probability of stock options coming into the underwater option is very greater in case of increasing the volatility and lengthening the time. In the state of underwater option the incentive intensity decreased, the executive's stock options reveal vulnerability. The characteristics of executive's stock options and lack of validity of capital markets have led to the vulnerability of the executive's stock options. The vulnerability is the important cause of incentive stock options in practice deviating from the track of theoretical design.The validity of corporate governance also is one of the prerequisites, which lead to implement equity incentive system. The paper analyzes the relationship between the mechanism of equity incentive and the mechanism of corporate governance including the mechanism of board of directors, the independent director system, the executive market, corporate control market, reputation, and product market competition. Because of lack of adequate validity of corporate governance, it is possible for the operation of mechanism of equity incentive in practice to deviate from the track of theoretical design. While the vulnerability of executive stock option reveals, some companies and executives manage incentives by their behaviors in order to maintain or restore incentive stock options. The instable mechanism of the executive's stock options ultimately hinder the validity of incentive stock options.Based on the above, the paper constructs a theoretical research framework, which explains the reasons and dynamic path for invalidity of incentive stock options. The lack of adequate validity of capital markets is external factor. The lack of adequate validity of corporate governance is internal factor. When the vulnerability of executives of stock occurs, some companies manage incentives by the re-pricing or re-grant options which result in the mechanism of incentive stock options deviating from the track of the theoretical design. It is difficulty ultimately to keep the interests of shareholders and the interest of executives consistent.In the last decade of 20th incentive stock options had rapidly developed in the United States. At the peak of the bull market, there are about one-third of the stock options being underwater option , the vulnerability of executive's stock option was obvious. There are empirical results showing that U.S. listed companies managed the vulnerability of stock options by company's re-pricing and re-grant. Based on the sample study, from a longer cycle of view (more than one year) the relationship between the option quantity (value) of the granted stock options and company performance revealed a V-type, that is, regardless of company stock return was up or down, the option quantity (value) was increasing. The empirical studies on U.S. incentive stock option confirm that there were the vulnerability of options and the instable mechanism of the executive's stock options in the practice of the United States, which illustrate the invalidity of incentive stock options.Since 2006 listed companies in China began to implement the normative equity-based incentives. There are a number of favorable conditions in China, while there are some adverse conditions, which may affect the validity of the incentive stock options. The paper chooses some listed companies, which have been implemented incentive stock options as the research object. The empirical studies have shown that incentive stock options have not improve corporate performance significantly, and shown that the ratio of underwater option is quite high, and shown that the change of incentive intensity of stock option in the rate of the stock return is not significant. In the sample period, regardless of company stock return was up or down, the change of total value of stock options was on the rise. The empirical results confirm that the incentive mechanism is not stable, which lead to conflicting interests between the shareholders and executives and confirm further that invalidity of incentive stock options for sample listed companies.After the theoretical analysis and empirical research, in order to prevent the mechanism of incentive stock options be instable and improve the validity of incentive stock options, the paper puts forward some advice on the design of incentive stock options. As the executive's heterogeneity of risk attitude, it is necessary to have diversity equity-based compensation programs at the same cost for executive to choose. In stock-based compensation programs, performance indicator will be an appropriate combination including subjective and objective indicator to assessment the executive's effort, which are help to adapt to environmental variability. Due to lack of adequate validity of capital market, indicator of relative performance and the indexed stock options and additional performance-conditioned stock options can be considered to applied, which can filter out the market and industry factors and avoid possible deviation of the incentive operating mechanism in future. For China's listed companies to improve the validity of incentive stock options, enhancing the validity and normative construction of China's capital market is an important content. The supervision and violation penalties related incentive stock option must be enhanced. It is necessary to improve the transparency of information on equity-based compensation and shareholder's participation in decision-making. Pay attention to the monitoring for equity-based incentives of listed company to prevent the negative effects of equity-based incentives. It is necessary to strictly regulate the behaviors of market intermediaries in the equity incentive mechanism. It is very important work for China's listed companies to strengthen the corporate governance in order to improve the validity of incentive stock options. On the basis of optimization ownership structure of listed companies, according to listed companies in China's case, the focuses of corporate governance are on the board governance mechanisms and the role of independent directors and the functions of supervisors. Some external mechanisms of corporate governance, such as controlling right market governance, executive market governance, and product market governance also must to be perfected.