Do Executive Stock Options Encourage Risk-Taking?

Randolph B. Cohen; Brian J. Hall; Luis M. Viceira

Other Unpublished Work | 2000

Do Executive Stock Options Encourage Risk-Taking?

by Randolph B. Cohen, Brian J. Hall and Luis M. Viceira

Abstract

Executive stock options create incentives for executives to manage firms in ways that maximize firm market value. Since options increase in value with the volatility of the underlying stock, executive stock options provide managers with incentives to take actions that increase firm risk. We find that executives respond to these incentives. There is a statistically significant relationship between increases in option holdings by executives and subsequent increases in firm risk. This relationship is robust to the inclusion of fixed effects, year effects, and a variety of other controls and does not seem to be driven by reverse causality. However, the estimated effect on risk-taking is small and we do not find a negative (or positive) market response to option-induced risk-taking. In sum, although options appear to increase firm risk, there is no evidence that this effect is either large or damaging to shareholders.

Keywords: Risk and Uncertainty; Motivation and Incentives; Stock Options; Executive Compensation;

Language: English

Format: Print

Read Now

Citation:

Cohen, Randolph B., Brian J. Hall, and Luis M. Viceira. "Do Executive Stock Options Encourage Risk-Taking?" 2000.

Our new model of consumption-based habit generates time-varying risk premia on bonds and stocks from loglinear, homoskedastic macroeconomic dynamics. Consumers' first-order condition for the real risk-free bond generates an exactly loglinear consumption Euler equation, commonly assumed in New Keynesian models. We estimate that the correlation between inflation and the output gap switched from negative to positive in 2001. Higher inflation lowers real bond returns, and higher output raises stock returns, explaining why the bond-stock return correlation changed from positive to negative. In the model, risk premia amplify this change in bond-stock return comovement and are crucial for a quantitative explanation.

We ﬁnd that the stocks in which active mutual fund or hedge fund managers display the most conviction towards ex-ante, their “Best ideas,” outperform the market, as well as the other stocks in those managers’ portfolios, by approximately 2.8 to 4.5 percent per year, depending on the benchmark employed. The vast majority of the other stocks managers hold do not exhibit signiﬁcant outperformance. Thus, the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolio that are not outperformers. We argue that investors would beneﬁt if managers held more concentrated portfolios.

Faculty & Research

Do Executive Stock Options Encourage Risk-Taking?

Abstract

Citation:

About the Authors

More from these Authors