CEO Stock Options and Equity Risk Incentives

Abstract

We test the hypothesis that the risk incentive effect of CEO stock option grants motivate managers to take on more risk than they would otherwise. The hypothesis is tested using a sample of completed mergers and also a broader cross-section of firms. For the merger sample, we document that variance increasing mergers are associated with greater CEO stock option risk incentives in the year prior to the merger announcement. We also find that mergers accompanied by leverage increases have greater CEO stock option risk incentives. These relationships are found to hold for NASDAQ firms but not for NYSE/AMEX firms. For the broader cross-sectional sample of firms we find that there is a strong positive relationship between CEO risk incentive embedded in the stock options and subsequent equity volatility. This evidence is stronger for NASDAQ firms than for NYSE/AMEX firms. Overall, our evidence supports the view that stock options are useful in moderating CEO's inherent preference for engaging in lower corporate risk activity than preferred by outside shareholders.

Keywords: compensation, structure, stock options, incentive effects, equity risk, firm performance

JEL Classification: J33, J41, G34