Equity‐Based Incentives, Risk Aversion, and Merger‐Related Risk‐Taking Behavior

AuthorBradley W. Benson,Wallace N. Davidson,Jung Chul Park
Published date01 February 2014
Date01 February 2014
The Financial Review 49 (2014) 117–148
Equity-Based Incentives, Risk Aversion,
and Merger-Related Risk-Taking Behavior
Bradley W. Benson
Ball State University
Jung Chul Park
Auburn University
Wallace N. Davidson III
Southern Illinois University
Wefind that post-merger equity risk is negatively related to the sensitivity of CEO wealth
to stock return volatility (vega), but is concentrated in CEOs with high proportions of options
and options that are more in-the-money. The probability of industrial diversification also
increases in vega. Additional tests show that the decline in post-merger equity risk results
in a significant decrease in shareholder wealth. This decrease is concentrated among firms
with CEOs having the highest delta and the highest delta and vega. Our results suggest that
the increased convexity provided by option-based compensation does not necessarily increase
risk-taking behavior by CEOs.
Keywords: managerial incentives, mergers and acquisitions, risk aversion, risk taking
JEL Classifications: G32, G34, J33
Corresponding author: Department of Finance and Insurance, Miller College of Business, Ball State
University,Muncie, IN 47306; Phone: (765) 285-5299; Fax: (765) 285-4314; E-mail: bbenson@bsu.edu.
We are especially grateful to the editors (Bonnie Van Ness and Robert Van Ness) and two anonymous
referees for their many insightful and constructive suggestions. We appreciate helpful comments from
seminar participants at Ball State University and the 2011 Financial Management Association Meeting.
C2014 The Eastern Finance Association 117
118 B. W. Benson et al./The Financial Review 49 (2014) 117–148
1. Introduction
A primary rationale for the use of executive stock options in CEO compensation
contracts is that they offset managerial risk aversion (Haugen and Senbet, 1981;
Smith and Stulz, 1985). The convex payoff function of option-based compensation
increases the sensitivity of CEO wealth to stock return volatility (vega). Higher vega
may persuade managers to take on greater risk (Coles, Daniel and Naveen, 2006),
which should discourage suboptimal investmentdecisions made by risk-averse CEOs.
Whether the convexity of higher vega overcomes managerial risk aversion remains a
theoretical and empirical question.
For instance, the effectiveness of option compensation depends on the man-
agerial utility function. Guay (1999) and Ross (2004) present models in which the
concavity of the manager’s utility function overcomes the convexity of the payoff
causing managers to be more risk averse. Option compensation increases the con-
vexity of the CEO’s payoff by increasing the sensitivity of CEO wealth to firm risk
which should unequivocally encourage CEOs to take more risk. But options are also
associated with an increased sensitivity of CEO wealth to stock price (delta). The
increase in delta may increase a CEO’s aversion to firm risk because the resulting
change in stock price has a larger impact on the value of the CEO’s firm-specific
portfolio. Specifically, the effect of high delta on stock return volatility depends on
whether the increase in value of the manager’s portfolio of stock and options, due
to higher risk, outweighs the decrease in value in the manager’s expected utility
resulting from increased volatility.
Further, vega is frequently measured in empirical studies using the marketvalue
(Black-Scholes value) of the stock option. This measure differs from the CEO’s
certainty equivalent value (the value of riskless cash the CEO would trade for the
risky asset). So, managers unable to sell or hedge their options will value them
differently than market value based on their personal risk preferences (Lambert,
Larcker and Verrecchia, 1991; Carpenter, 2000; Ross, 2004; Lewellen, 2006). Thus,
the net effect of option compensation on firm risk is unclear.
In this paper, we provide empirical evidence on the effect of equity-based in-
centives on risk taking incentives. We utilize mergers and acquisitions (M&As) as a
vehicle to test the effects of CEO vega on managerial risk taking because M&As are
a potential source of agency conflicts between managers and shareholders, while also
offering the opportunity to dramatically alter the risk profile of the firm. We examine
acquiring firm risk changes subsequent to 3,688 corporate M&As over the period of
1992–2005. We show a negative relation between CEO vega and post-merger equity
risk after controlling for CEO delta.
Our result contrasts with prior empirical studies examining the relation between
equity-based compensation and equity risk (e.g., Coles, Daniel and Naveen, 2006).
We begin by replicating the positive relation between CEO vega and equity risk
following Coles, Daniel and Naveen (2006). However, as in Brick, Palmon and
Wald (2012), the positive relation between CEO vega and total equity risk turns
B. W. Benson et al./The Financial Review 49 (2014) 117–148 119
negative after including year dummies and lagged equity risk. This suggests that
model specification may explain a portion of our conflicting results.
Wefurther investigate whether our results can be explained by the characteristics
of individual CEO option portfolios (the level of option ownership and the in-the-
moneyness of the options). Namely, high option ownership levels and in-the-money
options may exacerbate risk aversion (Carpenter, 2000; Ju, Leland and Senbet, 2002;
Tian, 2004; Parrino, Poteshman and Weisbach, 2005; Lewellen, 2006; Hjortshøj,
2007). Additionally, Hjortshøj (2007) shows an increase in volatility is associated
with a decrease in the certainty equivalent valuefor undiversified managers with more
in-the-money options. Thus, risk-averse managers with more in-the-money options
may have an incentive to take less risk. Consistent with these predictions, we observe
that the negative relation between vega and post-mergerrisk is concentrated in CEOs
with high proportions of options and options that are more in-the-money.
Finally, we find that the probability of industrial diversification, a potential risk
reduction channel, increases in vega. The decline in post-merger equity risk results
in a significant decrease in shareholder wealth which is concentrated among firms
whose CEOs have the highest delta and highest delta and vega (the effect of vega is
conditional on option ownership characteristics).
Overall, this study contributes to the literature examining the relation between
CEO’s equity-based incentives and firm’s investment decisions (more specifically
M&As), by showing that the increased convexity providedby option-based compen-
sation through the sensitivity of CEO wealth to stock return volatility,vega, does not
necessarily increase risk-taking behavior by CEOs. Additionally, the characteristics
of the option portfolios held by individual CEOs matter. Higher vega,combined with
high option ownership levels and in-the-money options may increase managerial
risk aversion. Our results provide new insights to the literature as well as generate
important practical implications.
2. Background, motivation, and development of hypothesis
2.1. M&As, agency conflicts, and acquisition-related risk
Although mergers may be motivated by many different and competing factors,
they may be a manifestation of agency problems. Agency costs associated with over-
investment by acquiring firms are often explained by the free cash flow hypothesis
(Jensen, 1986; Lang, Stulz and Walkling, 1991) and the hubris hypothesis (Roll,
1986). Acquiring firms may be subject to more severe information asymmetry prob-
lems from their complex structure of business operations. Given this elevatedlevel of
informational asymmetry, which is a necessary condition for agency problems (i.e.,
it provides more room for managers to absorb firm-specific information to pursue
their own benefits), such firms may be more likely to overinvest via M&As at the
cost of outside investors. For instance, Masulis, Wang and Xie (2007) show that
managers protected by antitakeover provisions (i.e., subject to weak market-imposed

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