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

• Author: Bradley W. Benson,Wallace N. Davidson,Jung Chul Park
• Published date: 01 February 2014
• DOI: http://doi.org/10.1111/fire.12028
• Date: 01 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

Abstract

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.

C2014 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