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

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...

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Bibliographic Details
Published in:Journal of financial economics 2012-04, Vol.104 (1), p.70-88
Main Authors: Armstrong, Christopher S., Vashishtha, Rahul
Format: Article
Language:English
Subjects:
Chief executive officers
Compensation
Equity
Equity incentives
Executive compensation
Financial incentives
Hedging
Investment policy
Risk aversion
Risk exposure
Risk-taking incentives
Stock options
Studies
Systematic and idiosyncratic risk
Systematization
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Summary: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.
ISSN:0304-405X
1879-2774
DOI:10.1016/j.jfineco.2011.11.005