Coase-Sandor Working Paper Series in Law and Economics

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Why do so many executives and other employees receive fixed stock options as part of their compensation packages? There is an impressive literature on compensatory options, and yet it raises more puzzles than it solves. Tax law, option theory, and agency theory all suggest that we might have expected to find quite different practices than we do observe. In particular, there is a puzzle in the popularity of conventional fixed options when indexed options would seem to be relatively attractive. The solution or story offered here develops arguments about signaling, in the form of employees' disinclination to be seen as preferring cash over options in their own employer’s future. It relies on the idea that indexed options encourage more risk alteration, or inefficient differentiation, than other forms of compensation. And it introduces the notion that there is something of a norm in favor of nonconflicting fortunes within a community. The norm part of the argument says something about the more general norm of privacy with respect to money matters and it illuminates the occasional practice of confidentiality regarding one’s own compensation. This practice might be stable because of the negative signals emitted by defectors. The same analysis might help explain why stock option practices are somewhat sticky.



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