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Market-Adjusted Options for Executive Compensation

Compensation theory implies that managers should not be rewarded or penalized for factors outside their control. However, firms do not adjust the exercise prices of executive stock options to reflect overall stock market movements which are outside the control of the manager. This results in an option that is more expensive than necessary to reward the same level of relative performance. Current accounting rules give firms a strong incentive not to adjust the prices of the options since it would result in a higher reported expense despite the lower economic cost. The cost of not adjusting the options is also calculated.