Executive stock options, differential risk-taking incentives, and firm value

Abstract

The sensitivity of stock options' payoff to return volatility, or vega, provides risk-averse CEOs with an incentive to increase their firms' risk more by increasing systematic rather than idiosyncratic risk. This effect manifests because any increase in the firm's systematic risk can be hedged by a CEO who can trade the market portfolio. Consistent with this prediction, we find that vega gives CEOs incentives to increase their firms' total risk by increasing systematic risk but not idiosyncratic risk. Collectively, our results suggest that stock options might not always encourage managers to pursue projects that are primarily characterized by idiosyncratic risk when projects with systematic risk are available as an alternative. Abstract: The sensitivity of stock options' payoff to return volatility, or vega, provides risk-averse CEOs with an incentive to increase their firms' risk more by increasing systematic rather than idiosyncratic risk. This effect manifests because any increase in the firm's systematic risk can be hedged by a CEO who can trade the market portfolio. Consistent with this prediction, we find that vega gives CEOs incentives to increase their firms' total risk by increasing systematic risk but not idiosyncratic risk. Collectively, our results suggest that stock options might not always encourage managers to pursue projects that are primarily characterized by idiosyncratic risk when projects with systematic risk are available as an alternative.

Do Stock Options Overcome Managerial Risk Aversion? Evidence from Exercises of Executive Stock Options

“…Our alternative conjecture should be more prominent among executives than among non-executive directors, because executives are likely to possess superior information about executives' ability and strategy and have a more direct influence on the 5 operations of the company (Harris and Raviv, 2008), and, hence, can better predict or influence the resolution of idiosyncratic uncertainty. Consistent with our conjecture (but inconsistent with the argument of Armstrong and Vashishtha, 2012), we show that executives are more likely to retain options when the idiosyncratic volatility is high than if the systematic volatility is high. In addition, we show that nonexecutive directors also retain options when faced with volatility, but show no preference for this volatility to be idiosyncratic.…”

“…We further examine Armstrong and Vashishtha's (2012) conjecture that executives with options can hedge any unwanted systematic volatility, and thus favor systematic to idiosyncratic volatility. But we also propose an alternative conjecture that executives believe they can better predict and influence the resolution of idiosyncratic uncertainty, and, thus, favor idiosyncratic uncertainty to systematic uncertainty when they have options.…”

“…Second, if systematic risk can be hedged, executives who are exposed to risk via undiversifiable equity prefer that the risk be systematic rather than idiosyncratic. Indeed, Armstrong and Vashishtha (2012) argue that "an increase in systematic risk always results in a greater increase in a CEO's subjective value of his stock-option portfolio than does an equivalent increase in idiosyncratic risk" (p. 86). The implication is that option exercises, e.g., for diversification reasons, are less likely when the systematic risk is high than when the idiosyncratic risk is high.…”

“…Armstrong and Vashishtha (2012) argue that executives with options favor exposure to systematic volatility, because systematic volatility inflates the value of the option positions and can be hedged if the executives are risk averse. We propose an alternative and novel conjecture that executives believe they can better predict or influence the resolution of idiosyncratic uncertainty, and, thus, favor idiosyncratic volatility to systematic volatility when they have options.…”

Executive Compensation: A Survey of Theory and Evidence

“…Observational studies typically con…rm the theoretical prediction that stronger equity incentives (higher "delta") are associated with less risk-taking, while convex equity incentives (higher "vega") are associated with more (see, for example, Agrawal and Mandelker, 1987;DeFusco, Johnson, and Zorn, 1990;Tufano, 1996;Guay, 1999;Rajgopal and Shevlin, 2002;Lewellen, 2006;Coles, Daniel, and Naveen, 2006;Armstrong and Vashishtha, 2012). However, it is again di¢ cult to interpret these correlations as causal.…”