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

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  • Armstrong, Christopher S.
  • Vashishtha, Rahul
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    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.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 104 (2012)
    Issue (Month): 1 ()
    Pages: 70-88

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    Handle: RePEc:eee:jfinec:v:104:y:2012:i:1:p:70-88

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Executive compensation; Equity incentives; Risk-taking incentives; Systematic and idiosyncratic risk; Hedging;

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    References

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    Cited by:
    1. Ahn, Seoungpil & Shrestha, Keshab, 2013. "The differential effects of classified boards on firm value," Journal of Banking & Finance, Elsevier, vol. 37(11), pages 3993-4013.
    2. Gormley, Todd A. & Matsa, David A. & Milbourn, Todd, 2013. "CEO compensation and corporate risk: Evidence from a natural experiment," Journal of Accounting and Economics, Elsevier, vol. 56(2), pages 79-101.
    3. Armstrong, Christopher S. & Larcker, David F. & Ormazabal, Gaizka & Taylor, Daniel J., 2012. "The Relation between Equity Incentives and Misreporting: The Role of Risk-Taking Incentives," Research Papers 2120, Stanford University, Graduate School of Business.
    4. Armstrong, Christopher S. & Larcker, David F. & Ormazabal, Gaizka & Taylor, Daniel J., 2013. "The relation between equity incentives and misreporting: The role of risk-taking incentives," Journal of Financial Economics, Elsevier, vol. 109(2), pages 327-350.

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