The NASPP Blog

A recently published study, “CEO Compensation and Corporate Risk-Taking: Evidence from a Natural Experiment” considers whether stock options encourage risk-taking behavior on the part of employees and executives. In today’s blog, I provide my thoughts on the study.

Risky Behavior and Stock Options
The study, which is summarized in the article “The Making of a Daredevil CEO: Why Stock Options Lead to More Risk Taking,” published by Knowledge@Wharton, looked at companies that had recently experienced an increased risk and evaluated which companies took steps to mitigate that risk based on the percentage of their managers’ compensation that is in stock options and the in-the-moneyness of the options.

The researchers found that firms where managers held more stock options took fewer mitigating actions. They felt that this is because once stock options are underwater, the value of the options can’t get any lower. When you think about it, with full value awards, there’s always upside potential but there’s also always downside potential–until the company is just about out of business, the value of the stock can always drop further. But once an option is underwater, it doesn’t matter how low the stock price drops, the option can’t be worth any less. As a result, managers in the study that held more options were less incented to take actions to keep the stock price steady.

Risk and In-the-Moneyness

Interestingly, and in line with this theory, the study also found that when managers’ had in-the-money options they took more mitigating action than when their options were underwater. If there was some spread in the options, the managers were motivated to preserve that spread and thus took action to keep the stock price from dropping. But where there was no spread, the managers were more incented to take risks (presumably in the hopes that the risks would pay off and the stock price would increase).

This is all very interesting; I’ve often wondered (probably here in this blog even) why the media and investors have a bias for full value awards over stock options–I think this is the first plausible explanation I’ve heard for that bias. But here in the NASPP Blog, we view studies like this with a healthy level of skepticism–it’s odd but I’ve never seen a study that didn’t prove the researchers’ initial hypothesis–so I wouldn’t scrap your option plan in favor of full value awards just yet (if you haven’t already done so).

A Nail in the Coffin for Premium-Price Options

I’ve never been a fan of premium-priced options because the reduction in expense is less than the premium, which, to my mind, makes them an inefficient form of compensation. I prefer discounted options, which provide a benefit that exceeds the additional expense to the company.

If this study can be believed, premium options would also discourage executives from taking steps to mitigate risk (whereas discounted options would presumably have the opposite impact). Maybe regulators and investors need to reconsider their bias against discounted options (although, in the case of the IRS, this bias may have less to do with concerns about risk taking and more to do with tax revenue–see my March 16, 2010 blog, “Discounted Stock Options: Inherently Evil or Smart Strategy“).

NASPP “To Do” List
We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog. 

– Barbara