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

Abstract

Using a sample of 3,688 mergers and acquisitions over the period of 1992 to 2005, we find that post-merger equity risk declines roughly 18% in the year after the announcement. We find that post-merger equity risk is negatively related to the sensitivity of CEO wealth to stock return volatility (vega). The negative relation between vega and equity risk over the post-merger period is concentrated in CEOs with high proportions of options and options that are more in-the-money. The reduction in post-merger equity risk is accomplished through both industrial diversification and reduced business segment focus, with the probability of industrial diversification decreasing in vega. In addition, we find 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, with the effect of vega also conditional on option ownership characteristics. Our results suggest that the increased convexity provided by option-based compensation does not necessarily increase risk-taking behavior by CEOs.