Explain index options. What are their advantages and disadvantages in terms of aligning employee interests with shareholder value? To what should these options be indexed?

What will be an ideal response?

Index options tie the exercise price to a peer index. Their major advantage is they make performance-based incentive compensation symmetric in both up and down markets. Thereby, they are able to reduce the variance of employee compensation. With index options, superior performance (relative to a peer group) is rewarded in growing and declining markets. Before an index option plan can be implemented, an appropriate performance measure (i.e., index) must be determined. Whatever index is chosen, it should filter out uncertainties that are beyond the control of employees. It should also be directly observable and resistant to manipulation.