J. C. de Swaan and Neil W. C. Harper

Since standard stock options don’t differentiate between value created by external factors and individual performance, investors may be shortchanged and CEOs may be rewarded regardless of merit and top-performing CEOs may be penalized if their tenure coincides with a bear market. Indeed, McKinsey research shows that from 1991 to 2000, market and industry factors drove about 70 percent of the returns of individual companies, company-specific factors only about 30 percent.

One way to home in on the unique value an individual creates is to strip out the effect of factors outside the control of executives as well as the return on equity expected by shareholders. What remains—reflecting improvements in performance or changes in expectations for which the executives were themselves responsible—should be compared with the achievements of their peers. In general, executives ought to be held accountable for their ability to meet the shareholders’ expectations as defined by the cost of equity. In addition, they should (and, presumably, would wish to) be rewarded for any individual value creation and penalized for any individual value destruction.

Indexed options can be a useful tool here. Unlike standard options, indexed ones make it possible to benchmark an executive against a set of his or her peers. Of course, making the right selection of peers is crucial: in the few cases in which indexed options have been employed for this purpose, their impact has been diluted by the use of too lenient or broad a definition of the peer group.

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