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

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  • Armstrong, Christopher S.
  • Vashishtha, Rahul

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.

Suggested Citation

  • Armstrong, Christopher S. & Vashishtha, Rahul, 2012. "Executive stock options, differential risk-taking incentives, and firm value," Journal of Financial Economics, Elsevier, vol. 104(1), pages 70-88.
  • Handle: RePEc:eee:jfinec:v:104:y:2012:i:1:p:70-88
    DOI: 10.1016/j.jfineco.2011.11.005
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    More about this item

    Keywords

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

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts
    • L25 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Firm Performance

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