Executive stock options and dynamic risk‐taking incentives

Abstract

PurposeThe purpose of this study is to present theory and empirical evidence on whether changes in leverage are systematically associated with changes in the CEO's risk incentives over time.Design/methodology/approach – A model is developed to explain the dynamic relationship between leverage and managers’ risk incentives, and empirically tested with data on executive stock option grants. The model relies on the observation that the risk sensitivity of a call option does not monotonically increase or decrease in the value of the underlying stock.Findings – It is found that changes in the CEO's risk incentives are not systematically correlated with changes in the firm's leverage over time.Research limitations/implications – The near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage, and therefore executives’ incentives to take equity risk are not correlated with firm leverage.Practical implications – For reasonable parameter values, this risk incentive‐maximizing stock price lies very close to the option's exercise price. This finding provides evidence that stock options plans granted approximately at‐the‐money encourage maximum risk‐taking by managers in a dynamic setting.Originality/value – This paper develops theory and evidence to explain why executive stock options are usually granted at‐the‐money.