New research from Wharton shows that stock options lead to more risk taking by CEOs.

The research is presented in a new paper, “CEO Compensation and Corporate Risk Taking: Evidence from a Natural Experiment,” by Gormley, David Matsa, a professor at Northwestern University’s Kellogg School of Management, and Todd Milbourn, a professor at Olin Business School at Washington University in St. Louis. “Options do have an effect on risk taking,” Gormley says. “That is something that should be factored into compensation structure by boards of directors.”

Stock options are a core element of CEO compensation representing 25% of total pay for US executives. Gormley wanted to explore what that meant for the risk profiles of the companies led by CEOs with options-based incentive plans. At the heart of the question are two opposing forces: options can act a risk control mechanism, because when they are “in the money”  the value of the options moves in line with the share price. That tends to dampen risk taking because CEOs want to preserve the value of those options.

At the same time, however, the downside of risk taking is limited because once the options are worth zero, they do not decline further in value if the share price falls. It is that limited downside increases the tendency to take on risk.

 “Our results provide tangible evidence that variation in compensation contracts can cause meaningful differences in corporate decisions,” the authors write.

 

Last Updated: 10 July 2011