CEO option wealth and firm risk-taking: An analysis of multiple reference points

Abstract

The behavioral agency literature focusing on how CEO stock option gains impact risk taking generates mixed findings, showing positive effect in some studies and negative effect in others. We reconcile this equivocality by introducing the pay reference point which delineates CEO options into both negative and positive deviation contexts. Building on the behavioral agency model and the myopic loss aversion concept derived from the theory of intertemporal preferences we conceptualize how pay reference points of CEO current and future option wealth directly affect risk taking and how bankruptcy likelihood and slack moderate this relationship. We suggest risk taking increases when both option wealth types are in a negative deviation context because CEOs strive to improve performance. In a positive deviation context, current wealth reduces risk taking as CEOs seek to protect their options but future wealth increases risk taking due to a longer option payoff horizon. For CEOs holding current and future option wealth, we argue bankruptcy likelihood weakens and amplifies risk taking respectively in the negative deviation context while slack facilitates risk taking in the positive deviation context. Empirical testing using a manufacturing panel dataset largely supports our hypotheses.