Indexed Stock Option

Indexed Stock Option

A stock option that may only be exercised if the company outperforms some stated index such as the S&P 500. This provides extra incentive for the employee (who is usually a senior executive) to see to it that the company performs well. Indexed stock options are favored by some ethical investment groups, as well as by some unions, because they reward performance for the company's work rather than the executive's ability to detect an advantageous moment in the market.
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Indexed stock option grants reward executives for outperforming a benchmark, such as the market as a whole or competitors in the same industry.(1) These options offer superior incentives by limiting the influence of factors beyond an executive's control, such as general market and industry conditions.(2) Yet indexed options are almost never used.(3) Professor Saul Levmore seeks to explain this puzzle with norms.(4) This comment on his article argues that tax plays a larger role in this puzzle than he acknowledges, although tax is not a complete explanation.(5) Accounting and Professor Levmore's norms-based account are then briefly considered.
Other companies using indexed stock options include Level 3 Communications, Chiron, Capital One, RCN Corp., Perceptron, and Nuvelo.
It is harder to explain the apparent dominance of conventional stock options over indexed stock options. The standard explanation focuses on accounting treatments, but this sort of explanation defies normal assumptions about rational investors.