The Effect of Executive Stock Option Plans on Stockholders and Bondholders

Abstract

Executive stock option plans have asymmetric payoffs that could induce managers to take on more risk. Evidence from traded call options and stock return data supports this notion. Implicit share price variance, computed from the Black-Scholes option pricing model, and stock return variance increase after the approval of an executive stock option plan. The event is accompanied by a significant positive stock and a negative bond market reaction. This evidence is consistent with the notion that executive stock options may induce a wealth transfer from bondholders to stockholders. (1981)). The typical stock option plan grants the executive the option to purchase a number of shares of common stock at a stated exercise price that is normally equivalent to the market value of the stock on the date of the grant. These options differ from listed options in that there is usually a minimum holding period required before the options can be exercised. In addition, the options are long-term in nature (typically ten years) and are strictly nonmarketable. MANAGERIAL STOCK OPTIONS HAVE been proposed as a method that ameliorates the agency problems that exist between managers and shareholders (Haugen and SenbetSince Jensen and Meckling (1976), it has been widely held that agency costs are reduced by relating an executive's compensation to firm performance (e.g., Beck and Zorn (1982) and Haugen and Senbet (1981)). The empirical evidence indicates that proposed changes in long-range managerial compensation plans (option, restricted stock, performance, stock appreciation rights, and phantom stock) are met with positive share price reactions (e.g., Brickley, Bhagat, and Lease (1985)).The positive share price reaction to the announcement of executive stock option plans is consistent with the contention that these plans improve managerial incentives. Improved incentives are the reason most often cited by firms seeking shareholder approval for the adoption of stock option plans. A study by Masson (1971) found that firms with compensation packages that emphasize stock market performance (and de-emphasize other firm performance measures) outperform firms without such an arrangement. Murphy (1985) also finds that

The Effect of CEO Risk Appetite on Firm Volatility: An Empirical Analysis of Financial Firms☆

“…Many of these studies look at the effect of managerial equity based compensation on firm risk in the context of the agency conflict that opposes managers and shareholders. In the non-financial sector, for example, Agarwal and Mandelker (1987), DeFusco et al (1990) and Chok and Sun (2007) find a positive relationship between firm risk and option-based compensation. In the financial sector, Saunders et al (1990) find that banks with high managerial equity ownership exhibit greater risk than those with low managerial equity ownership, while Chen et al (1998), employing a similar methodology over a different time period, find the contrary.…”

A Review of Employee Stock Option Plans: Panacea or Pandora’s Box for Firm Performance

“…A plethora of literature exists on the impact of stock options in US and Europe; impact on share price (Brickley et al, 1985) [5]; impact on accounting profits (DeFusco et al, 1990 [16]; Chen and Lee, 2010) [7]and impact on risk taking behavior (DeFusco et al1990 [16]; Rajgopal and Shevlin, 2002[47] and Chen and Lee, 2010) [7].…”

“…Moreover, manager's concern for job security underpins a riskaverse behavior, wherein they have a tendency of avoiding risky investment projects. DeFusco et al (1990) [16]provided empirical evidence of the risk-averse hypothesis and found an increase in the variability of stock returns for firms announcing the adoption of stock options plans in US. In Singapore, Soon (2001) [54]advocated that firms adopting stock options are less risk taking and cash strapped and found that firms adopting ESOs are encouraging risk taking behavior leading to better performance than their competitors.…”

Negative Hedging: Performance-Sensitive Debt and CEOs’ Equity Incentives

“…Important papers in this area include Agrawal and Mandelker (1987), DeFusco, Johnson andZorn (1990), Parrino andWeisbach (1999), Cohen, Hall, and Viciera (2000), Jin (2002), and Knopf, Nam, and Thornton (2002). This paper proceeds as follows.…”