Abstract
I investigate whether CEO stock options differentially affect the firm’s systematic and idiosyncratic risk. To examine a causal effect of option compensation on the firm’s systematic and idiosyncratic risk, I exploit the passage of Financial Accounting Standard no. 123R as an exogenous shock to CEO option compensation. According to the Capital Asset Pricing Model (CAPM), only systematic risk is priced since investors can eliminate idiosyncratic risk through diversification. Unlike risk-neutral shareholders, riskaverse CEOs have limited ability to eliminate idiosyncratic (or firm-specific) risk because since they usually hold large positions in their firms and are often prohibited from hedging the firm-specific risk associated with their compensation. Thus, idiosyncratic risk is unwanted by under-diversified CEOs. Consistent with this idea, I find that, although CEO option compensation is positively associated with the total risk, it is negatively associated with the ratio of idiosyncratic to total risk.
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