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BLOG: Daredevil Execs? Why Stock Options Lead to More Risk

Ed Zwirn | July 23, 2011
Options-laden compensation packages boost risk-taking, a Wharton, Kellogg and Olin study shows.

It's long been a truism that the content of executive compensation packages affects management decisions. Now, a study provides a concrete analysis of compensation's effect on risk taking -- at least when it comes to the awarding of stock options.

Todd Gormley of Penn's Wharton School, David Matsa of Northwestern's Kellogg School of Management, and Todd Milbourn of the Olin Business School at Washington University in St. Louis looked at 69 companies in industries likely to suffer exposure as a result of the federal government's decision to label a specific material --- one handled by company employees --- as a possible carcinogen.

"The concern for some companies would be if some chemical they used was the next asbestos," Gormley tells Knowledge@Wharton, the business school's online publication. "That would bring significant legal liability and costly regulatory changes."

The authors found that CEOs with compensation that is "more like straight equity," such as restricted stock, a high sensitivity to stock price movements, and deep in-the-money options, tended to reduce cash flow volatility after these risks increased.

On the other hand, firms with CEOs whose compensation is "heavily weighted on the upside (e.g., more out-of-the money options and a high sensitivity to stock price volatility) tend to roll the dice by not reducing cash flow volatility as to insulate the firm from the risk."

These effects, according to the authors, "highlight the importance of boards structuring executives' compensation correctly in order to complement their desired corporate strategy." Particularly, granting stock options "that are far out of the money encourage the greatest risk taking, even while they are relatively inexpensive when issued."

The authors also point out that, although their paper didn't study financial firms directly, the "results suggest that this sort of compensation scheme with option-like features and limited clawback provisions will provide strong incentives for corporate risk taking."

The results, they write, "provide tangible evidence that variation in compensation contracts can cause meaningful differences in corporate decisions" and "confirm the importance of boards both structuring and maintaining executives' compensation properly in order to achieve their desired corporate strategy."

But rather than there being a particular best compensation structure for all companies facing "significant tail risk," the optimal compensation structure will likely depend on a firm's specific circumstances.

"Boards can structure managers' equity compensation to encourage or discourage risk taking, according to the board's objectives," they write.


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