Loss Aversion, Instant Endowment and Risk-Bearing: The Relation between Stock-Based Compensation and Managerial Risk-Seeking Behavior

Abstract

We examine the extent to which the behavioral agency model describes the relation between stock-based compensation and managerial risk-seeking behavior. The behavioral agency model, which incorporates prospect theory, predicts that while managers are more risk-seeking in the loss decision context than in the gain decision context because of loss aversion, such risk-seeking behavior in the loss context is mitigated because managers instantly endow stock-based compensation (i.e., wealth at stake), which increases their risk-bearing. We find that in general, managers are more risk-seeking in the loss context than in the gain context, consistent with prospect theory. Contrary to prospect theory, however, we find that managers endowed with in-the-money stock options are less risk-seeking than managers endowed with at-the-money stock options. This finding is also contrary to agency theory which generally predicts that stock options encourage risk-seeking behavior. We also explore whether managers' subjective valuation of stock options is associated with risk-seeking behavior. We find evidence consistent with managers valuing stock options more than restricted stock of similar objective value. Overall, our results support the propositions based on the behavioral agency model. Moreover, managers appear to consider both risk-bearing as well as subjective valuations of stock-based compensation in their decision-making process. Our findings are important for those using and evaluating the efficacy of different types of stock-based compensation in inducing firm value-increasing risk-seeking behavior.