Stock options and managerial incentives to invest -

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Researchers looking to examine the incentive effects of executive
stock options are confronted with two immediate challenges. First,
standard Black Scholes risk-neutral valuation techniques are inaccurate
because executive stock options are not traded, and they are frequently
held by managers with undiversified wealth (including human capital)
facing short-sale and liquidity constraints.

Second, option values are inextricably linked to executive actions
and firm value. If options didn’t affect managerial behavior, and if
managerial behavior didn’t affect firm value, then why would firms
choose to grant options? The fact that options are a large and growing
portion of U.S. executive pay (Murphy, 1999), that firms routinely
re-price stock options (Brenner, Sundaram and Yermack, 2000), that
largely as a result of stock option pay, U.S. executives, on average,
hold a claim on more than 3% of their firms’ shares (Conyon and Murphy,
2000), all these facts suggest that the agency problems between managers
and shareholders are large and that the benefits of stock option
compensation are potentially great.