The Effect of Executive Stock Options on Corporate Innovative Activities

• DOI: http://doi.org/10.1111/fima.12036
• Author: Carl R. Chen,Yenn‐Ru Chen,Chih‐Kang Chu
• Published date: 01 June 2014
• Date: 01 June 2014

The Effect of Executive Stock Options

on Corporate Innovative Activities

Yenn-Ru Chen, Carl R. Chen, and Chih-Kang Chu∗

This study investigates whether the implicit optionality of executive stock options (ESOs) induce

managers to undertake innovativeactivities associated with various types of risk. We find ESO risk

incentive (vega) to be positively correlated with all types of corporate innovations. We also find

greater ESO risk incentive effects for the product-related innovative activities that are associated

more with systematic risk than idiosyncraticrisk. Finally, we document the followingpecking order

for the ESO risk incentive effects: improvedproduct, new product, alliance, and new researchand

development. Our results suggest that executives have more incentive to invest in projects with

higher systematic risk.

Prior research provides two opposite predictions regarding whether executive stock options

(ESOs) can increase managerial risk-taking. The convexity payoff scheme of ESOs suggests that

ESOs can increase managerial risk-taking (Haugen and Senbet, 1981; Smith and Stulz, 1985).

The Rajgopal and Shevlin (2002) finding of a positive correlation between the risk incentive

of ESOs and future oil exploration supports this prediction. Alternatively, the risk aversion of

executives may constrain the incentive effect of ESOs on managerial risk-taking (Ju, Leland,

and Senbet, 2002; Larraza-Kintana et al., 2007). Moreover, Lambert, Larcker, and Verrecchia

(1991), Carpenter (2000), and Ross (2004) argue that risk-averse executives may not always

increase their risk appetite with the risk incentive of ESOs, unless the incentive is high enough

to change their utility of wealth. Recently, Chen and Lee (2010) find that although ESOs may

induce managerial risk-taking, this risk-taking incentive is short-lived. Thus, they conclude that

ESOs may not always function as long-term incentive compensation as expected.

Recent studies positing that the risk incentive effect of ESOs varies with the type of risk-taking

may reconcile these seeminglyconflicting arguments. For example, with limited capital resources,

ESOs provide chief executive officers (CEOs) with an incentive to allocate resources to intangible

investments such as research and development(R&D) versus tangible investments such as capital

expenditures (Cole, Daniel, and Naveen, 2006). Alternatively, the vega effect of ESOs provides

CEOs with an incentive to engage in corporate activities that are associated with different types

of risk, systematic and idiosyncratic risks (Tian, 2004; Duan and Wei, 2005; Armstrong and

Vashishtha, 2012). ESOs provide both the delta and vega incentives. The delta effect provides

an incentive to increase stock price, while the vega effect provides an incentive to increase stock

return volatility (i.e., risk). These studies identify that the vega effect (risk incentive effect) of

ESOs increases firm risk primarily through the increase of systematic risk rather than through

the increase of idiosyncratic risk. Therefore, ESOs may not necessarily provide executives with

the incentive to invest in a project that has a positive net present value (NPV) and also high

This paper has greatly benefited from the comments of an anonymous reviewer and Bill Christie and Marc Lipson

(Editors).

∗Yenn-RuChen is an Associate Professor of Finance at National Cheng Kung University in Tainan,Taiwan. Carl R. Chen

is the William J. Hoben Professor of Finance at the University of Dayton in Dayton, OH. Chih-Kang Chu is a former

research assistant at the GraduateInstitute of Finance at National Cheng Kung University in Tainan, Taiwan.

Financial Management •Summer 2014 •pages 271 - 290

272 Financial Management rSummer 2014

idiosyncratic risk. Given that the majority of CEOs in the US rank stimulating innovation as

one of their top objectives for firm long-term growth and profitability (Rudis, 2004), this study

extends the ESO literature by investigating whetherESOs provide managers with an incentive to

undertake various innovative activities associated with different types of risk.1

We contribute to the literature in two ways: First, we identify the incentives (delta and vega)

of ESOs and relate them to a wide spectrum of corporate innovative activities measured by

new products, improved products, technologicalalliances, and new R&D activities. Additionally,

while the literature has made distinctions between different types of investment activities and

their effects on firm risk (Cole et al., 2006), we extend this strand of literature and distinguish

the relation between different innovative activities and systematic risk/idiosyncratic risk. This

distinction makes a discussion on ESO risk incentive (vega) more economically intuitive, as

predicted in Pastor and Veronesi (2009).

Thus, our objectives are twofold. First, in contrast to Quinn and Rivoli (1991), Hoskisson,

Hitt, and Hill (1993), Holthausen, Larcker, and Sloan (1995), and Ryan and Wiggins (2002),

who examine the correlation between the Black-Scholes (1973) value of ESOs and managerial

innovation, we adopt a framework that directly links ESO risk incentive (vega) to corporate

innovation. According to Guay(1999) and Core and Guay (2002), the incentives of ESOs closely

align stock return volatility with the value of managerial option holdings. In other words, using

the risk incentive (vega) of ESOs rather than the Black-Scholes (1973), option value may better

reflect the original purpose of granting ESOs (i.e., to induce the incentive to innovate). As such,

we contend that the risk-taking incentive (vega) of ESOs, rather than the value of ESOs, should

be examined when investigating the impact of ESOs on corporate innovative activities.

Additionally, we examine the ESO risk incentive effect (vega effect) on various corporate

innovative activities with different risk levels/types. According to Abernathy and Clark (1985),

Daniel (2002), and Benner and Tushman(2003), innovations can be classified into exploitative and

exploratory innovations, each of whichis associated with different levels of risk. The undertaking

of different types of innovationwould be followed by differentlevels of risk. Therefore, executives

may choose to undertake innovations associated with preferred risk levels to respond to the

incentive effects of ESOs.

More importantly,t he classification of innovative activities into different categories sheds light

on the recent finance literature demonstrating different incentives of ESOs on various types of risk.

For instance, some studies indicate the theoretical importance of distinguishing systematic risk

from idiosyncratic risk in examining the correlation between ESOs and firm risk (Tian, 2004;

Duan and Wei, 2005; Henderson, 2005). Recently, Armstrong and Vashishtha (2012) provide

empirical evidence that the risk incentive of ESOs (i.e., vega) encourages CEOs to increase firm

risk by increasing systematic risk, but not idiosyncratic risk. In addition, Pastor and Veronesi

(2009) argue that firms are more associated with idiosyncratic risk than systematic risk before

they commit to the adoption of new technology in their production.

Our findings and their implications can be summarized as follows. First, there exists a positive

and significant relationship between corporate innovation and ESO risk incentive (vega), indicat-

ing a managerial risk-taking effect from ESO risk incentives. In addition, risk incentive differs

among various innovative activities. Generally speaking, the risk incentive effectof various inno-

vativeactivities follows the following pecking order: 1) product improvement, 2) newproducts, 3)

technological alliance, and 4) new R&D. These results are consistent with the production theory

of Pastor and Veronesi (2009) and the findings of Armstrong and Vashishtha (2012) that ESOs

1Rudis (2004) finds that nearly 78% of the 540 CEOs interviewed rank stimulating innovation, creativity, and enabling

entrepreneurship to be their top objectives.