Executive Stock Options, Differential Risk-Taking Incentives, and Firm Value

The following post comes to us from Christopher Armstrong and Rahul Vashishtha, both of the Accounting Department at the University of Pennsylvania.

In our paper, Executive Stock Options, Differential Risk-Taking Incentives, and Firm Value, forthcoming in the Journal of Financial Economics, we examine how executive stock options (ESOs) give chief executive officers (CEOs) differential incentives to alter their firms’ systematic and idiosyncratic risk. Since ESOs give CEOs incentives to alter their firms’ risk profile through both their sensitivity to stock return volatility, or vega, and their sensitivity to stock price, or delta, we examine both effects.

Theory suggests that vega gives risk-averse managers more of an incentive to increase total risk by increasing systematic rather than idiosyncratic risk, since, for a given level of vega, an increase in systematic risk always results in a greater increase in a CEO’s subjective value of his or her stock-option portfolio than does an equivalent increase in idiosyncratic risk. This differential risk-taking incentive manifests because a CEO who can trade the market portfolio can hedge any unwanted increase in the firm’s systematic risk. Consistent with this prediction, we provide evidence of a strong positive relationship between vega and the level of both total and systematic risk. However, we do not find vega and idiosyncratic risk to be significantly related.

ESOs also give CEOs incentives to alter their firms’ risk profile through their sensitivity to stock price, or delta. We find that delta is positively related to the level of both systematic and idiosyncratic, and therefore total, risk. The positive relationship between delta and idiosyncratic risk is particularly noteworthy and suggests that investing in positive-NPV projects may require managers to increase idiosyncratic risk even though it cannot be hedged.

Our results challenge the popular belief that ESOs can be used to overcome risk-averse CEOs’ aversion to investing in risky but positive-NPV projects. Our findings suggest that ESOs may not necessarily induce CEOs to undertake positive-NPV projects if these projects are primarily characterized by idiosyncratic risk and opportunities to increase systematic risk are available. Our findings also raise the possibility that ESOs may induce managers to increase their firms’ systematic risk, which they can hedge, even if it does not increase firm value. This can adversely affect shareholders in two ways. First, there could be costs associated with managerial time and effort spent seeking systematic risk that does not necessarily increase firm value. Second, it could lead to excessive systematic risk in equity markets, which may, in turn, lead to reduced risk-sharing among investors and lower firm values.

The full paper is available for download here.

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