The Trouble with Stock Options

The benefits of stock options are often not large enough to offset the inefficiency implied by the large divergence between the cost of options to companies and the value of options to risk-averse, undiversified executives and employees. Moreover, the benefits of options can often be achieved more effectively and economically through other means. Why are options so prevalent? Several explanations include changes in corporate governance, reporting requirements, taxes, the bull market and managerial rent-seeking. We offer an alternative hypothesis: boards and managers incorrectly perceive stock options to be inexpensive because options create no accounting charge and require no cash outlay.