How Do Quasi‐Random Option Grants Affect CEO Risk‐Taking?

• Published date: 01 December 2017
• DOI: http://doi.org/10.1111/jofi.12545
• Date: 01 December 2017

THE JOURNAL OF FINANCE •VOL. LXXII, NO. 6 •DECEMBER 2017

How Do Quasi-Random Option Grants Affect

CEO Risk-Taking?

KELLY SHUE and RICHARD R. TOWNSEND∗

ABSTRACT

We examine how an increase in stock option grants affects CEO risk-taking. The

overall net effect of option grants is theoretically ambiguous for risk-averse CEOs.

To overcome the endogeneity of option grants, we exploit institutional features of

multiyear compensation plans, which generate two distinct types of variation in the

timing of when large increases in new at-the-money options are granted. We find that,

given average grant levels during our sample period, a 10% increase in new options

granted leads to a 2.8% to 4.2% increase in equity volatility. This increase in risk is

driven largely by increased leverage.

PERFORMANCE-SENSITIVE PAY FOR EXECUTIVES has surged over the last 30 years.

Much of this surge has been in the form of stock options, which became the

largest component of executive compensation in the 1990s, accounting for ap-

proximately 50% of the total compensation of S&P 500 CEOs by the end of

the decade. Following changes in the accounting treatment of options in 2005,

the use of options declined. Still, options remain a major component of CEO

pay, accounting for over 20% of total pay (Murphy (2013)). Moreover, Bettis

et al. (2012) find that many firms have substituted from option grants toward

performance-vesting stock grants, which have option-like payoffs. Similar to

an option, a performance-vesting share provides zero payoff below some perfor-

mance threshold and increasing payoffs above the threshold. As of 2008, nearly

∗Kelly Shue is with YaleUniversity, School of Management and NBER; Richard Townsend (cor-

responding author) is with the University of California San Diego, Rady School of Management.

We are grateful to Michael Roberts (the Editor), the Associate Editor, two anonymous referees,

Marianne Bertrand, Ing-Haw Cheng, Ken French, Ed Glaeser, ToddGormley, Ben Iverson (discus-

sant), Steve Kaplan, Borja Larrain (discussant), Jonathan Lewellen, Katharina Lewellen, David

Matsa (discussant), David Metzger (discussant), TobyMoskowitz, Candice Prendergast, Enrichetta

Ravina (discussant), Amit Seru, and Wei Wang (discussant) for helpful suggestions. We thank

seminar participants at AFA, BYU, CICF Conference, Depaul, Duke, Gerzensee ESSFM, Harvard,

HKUST Finance Symposium, McGill Todai Conference, Finance UC Chile, Helsinki, IDC Herzliya

Finance Conference, NBER Corporate Finance and Personnel Meetings, SEC, Simon Fraser Uni-

versity, Stanford, Stockholm School of Economics, Universityof Amsterdam, UC Berkeley, UCLA,

and Wharton for helpful comments. We thank David Yermack for his generosity in sharing data.

We thank Matt Turner at Pearl Meyer, Don Delves at the Delves Group, and Stephen O’Byrne

at Shareholder Value Advisors for helping us understand the intricacies of executive stock option

plans. Menaka Hampole provided excellent research assistance. We acknowledge financial support

from the Initiative on Global Markets. The authors have no conflicts of interest to disclose.

DOI: 10.1111/jofi.12545

2551

2552 The Journal of Finance R

40% of equity awards were characterized by performance vesting rather than

simple time vesting. Given the prevalence of options and option-like compen-

sation, it is important to understand the extent to which these forms of pay

affect CEO decision-making. In particular, there is a long-standing and impor-

tant question dating back to Jensen and Meckling (1976) of whether options

influence CEO risk-taking behavior.

The idea that stock options create incentives for risk-taking is rooted in the

convexity of their payoffs: if the underlying stock price rises above the strike

price, the option holder earns the difference, but if the stock price drops be-

low the strike price, the option holder does not lose the difference. However,

in addition to this “convexity effect,” Ross (2004) shows that options can have

a countervailing “magnification effect.” The magnification effect is driven by

the fact that options increase the sensitivity of an executive’s wealth to the

underlying stock price, which may lead a risk-averse executive to want to

decrease risk. In practice, it is also possible that options have no effect on

risk-taking if executives are sufficiently well monitored or if they are able to

hedge their option holdings (Garvey and Milbourn (2003)). Thus, the over-

all effect of option compensation on risk-taking is ultimately an empirical

question.1

Estimating the effect of options on risk-taking is difficult due to endogeneity

issues. The main challenge is that an omitted factor could affect both options

and risk-taking. For example, if value-maximizing firms believe that options

increase risk-taking, they may increase option pay exactly when the benefits

to risk-taking are greater (i.e., when there are more risky positive net present

value (NPV) projects). In this case, risk-taking may increase due to option

pay or because the CEO is responding to the firm’s need for more risk-taking.

While much of the existing research on options and risk-taking has been corre-

lational in nature, two recent studies by Chava and Purnanandam (2010)and

Hayes, Lemmon, and Qiu (2012) attempt to address these endogeneity issues

by examining how executive risk-taking changed when option use declined

following the change in the accounting treatment of options in 2005. How-

ever, firms that decreased option compensation after the reform also tended

to increase stock compensation at the same time. As a result, this experiment

is not ideal for isolating the total net effect of options—for risk-averse man-

agers, stock compensation affects risk-taking incentives as well. Furthermore,

Bettis et al. (2012) point out that the confounding effect of the increase in stock

compensation is exacerbated by the fact that much of the stock compensation

was in the form of performance-vesting shares, which have option-like con-

vex payoffs. Finally, the regulatory change affected all firms simultaneously,

so there is no control group available to estimate the counterfactual change

1The magnification effect has also been noted by Lambert, Larcker, and Verrecchia (1991),

Carpenter (2000), Hall and Murphy (2002), and Lewellen (2006), among others. Options may also

have other ambiguous implications for risk. For example, options increase in value with firm

performance, and managers may increase or decrease firm risk in the pursuit of stronger firm

performance. In addition, option compensation increases wealth, which may alter risk tolerance.

How Do Quasi-Random Option Grants Affect CEO Risk-Taking? 2553

in risk-taking that would have occurred over the same time period absent the

reform.2

Toidentify a causal effect of options on risk-taking, the ideal test would utilize

exogenous variation in option pay that is staggered across firms over time. In

this paper, we exploit a natural experiment that delivers such variation. Our

identification strategy builds on Hall’s (1999)) observation that firms often

award options according to multiyear plans. Two types of plans are commonly

used: fixed-number and fixed-value.3Under a fixed-number plan, an executive

receives the same number of options each year within a cycle. Under a fixed-

value plan, an executive receives the same value of options each year within

a cycle. Cycles are generally short, lasting about two years, after which a new

cycle typically begins.

Multiyear plans give us two distinct sources of variation in the timing of

option pay increases. Our first instrumental variables (IV) strategy uses only

CEOs on fixed-value plans. For these executives, option compensation tends

to follow an increasing step function. During a fixed-value cycle, the value of

options granted is held constant. At the beginning of a new cycle, there is a

discrete increase in the value of option grants, on average. The timing of when

these steps occur is staggered across firms. These staggered steps motivate our

first instrument: an indicator variable for whether each CEO-year is predicted

to be the first year of a new fixed-value cycle. We use predicted cycle first years

instead of actual cycle first years as our instrument because the timing of

when new cycles actually begin may be endogenously renegotiated between the

manager and the board. For example, a manager may negotiate to prematurely

start a new cycle for some unobserved reason that also directly relates to the

firm’s risk. Instead, we use a predicted first-year indicator, which corresponds

to when new cycles would likely have started if renegotiation had not taken

place. Our predictions exploit the fact that firms tend to use repeated cycles

of equal length. We use the length of a manager’s previous cycle to predict

when the next cycle will begin. Predictions are therefore based only on past

information. For example, if a manager had cycles starting in 1990 and 1992,

we would predict that a new cycle would start in 1994. Assuming that firms do

not set the length of the current cycle in anticipation of risk-taking conditions

at the start of future cycles, the predicted first year instrument should purge

the estimation of bias from renegotiation.

Our second IV strategy does not use the timing of cycle first years, but

rather uses variation in the value of options granted within fixed-number and

fixed-value cycles. We exploit the fact that the Black-Scholes value of an at-

the-money option increases proportionally with its strike price. As Hall (1999)

2Using a different strategy, Gormley, Matsa, and Milbourn (2013) examine responses to an

exogenous increase in firm litigation risk. The exogenous nature of the shock helps rule out reverse

causality and allows the authors to explore an important related question: how does a change in

risk affect option compensation? However, to identify a causal effect of options on risk-taking, the

ideal test would utilize exogenous variation in option pay rather than in the risk environment.

3Hall (1999) describes multiyear grant cycles in detail, but does not use them as an instrument

to explore the effect of options on managerial behavior.